8. How To Save for a Down Payment (and Other Big Purchases)

Why your time horizon is so important

YOU’VE DECIDED TO take a big leap.

You want to buy your first home. Or maybe you want to get married, or maybe you just desire a new car. Whatever you have your heart set on, it’s time to save up.

But, what’s the best way to do that? Should you let your money sit in cash, or should you invest it while you wait?

I asked a few financial advisors that I have worked with over the years and they all responded in the same way—cash, cash, cash. When it comes to saving for a down payment (or other big ticket item), cash is the safest way to get there. Period. Full stop.

I already know what you’re thinking. What about inflation? Yes, inflation is going to cost you a couple of percentage points a year while you save. However, given that you are only saving for a short period of time (a few years), the impact will be small.

For example, if you needed to save up $24,000 for a down payment on a house and you could afford to save $1,000 a month, it would take you 24 months (two years) to get there without inflation.

However, with 2% annual inflation, it’s going take you an extra month of saving $1,000 to reach your goal. That means that you would have to save $25,000 nominal dollars to get $24,000 of real purchasing power in two years’ time thanks to inflation.

Yes, this isn’t ideal, but it’s a small price to pay for the guarantee that you will have your money when you need it. In the grand scheme of things, the extra month isn’t a significant cost. This is why cash is the most sure-fire, lowest risk way to save for a big upcoming purchase.

But what if you wanted to fight inflation while you were saving? Or what if you needed to save for a period longer than two years? Is cash still the best option?

To answer this let’s look at how saving in cash compares to saving in bonds throughout history.

Does Saving in Bonds Beat Cash?

To test whether investing in bonds beats holding cash, we can run the same exercise of saving $1,000 a month, but this time we will invest that money in U.S. Treasury bonds. We do this via an exchange-traded fund (ETF) or index fund. By buying U.S. Treasury bonds we can earn some return on our money while also holding a low-risk asset.

What’s not to like?

Well, low risk isn’t the same as no risk. As the chart below illustrates, intermediate-term U.S. Treasury bonds regularly decline by 3% or more in value.

These normal fluctuations in bond prices illustrate why investing your savings into bonds could push your goal further into the future compared to saving in cash.

Going back to our example of saving $1,000 a month until you reach $24,000, a 3% drop in bond prices near the finish line would reduce your portfolio value by nearly $750 (~3% of $24,000). This decline in value would be worse than a similar drop earlier in time because you have more money invested and, thus, more to lose.

To counteract this decline, you would have to save an extra $1,000 (i.e., save for one additional month) to reach your $24,000 goal. Even with bonds, it can take more than the expected 24 months to reach your saving goals.

In fact, if we re-run this saving scenario across every period going back to 1926, this is exactly what we find. On average it takes 25 months to save $24,000 when investing $1,000 a month in U.S. Treasury bonds (after adjusting for inflation).

As you can see, when we invest in bonds sometimes it takes us more than 25 months to reach our goal and sometimes it takes less.

Nevertheless, investing in bonds still takes less time to reach our goal than saving in cash. If we re-run the exercise above by saving in cash going back to 1926, we find that it actually takes 26 months on average to reach our $24,000 savings goal after adjusting for inflation.

Why is this longer than the 25 months I mentioned earlier? Because inflation has varied over time! If inflation was a constant 2%, then cash would always take 25 months to reach the $24,000 goal.

However, higher inflation means that it will take you more time to reach your savings goal. In fact, in some periods it would have taken you almost 30 months of saving $1,000 in cash to reach your $24,000 goal.

Though bonds typically beat cash when saving for about two years, they don’t beat them by much. As I stated above, it takes 25 months to save $24,000 when in bonds and 26 months when saving in cash.

Having to save for one extra month is a small inconvenience compared to worrying about whether bond prices might tumble when you need your money.

In fact, about 30% of the time since 1926 you would have been the same, or better off, holding cash versus investing in bonds to reach your $24,000 goal.

This suggests that when saving for less than two years, cash is probably the optimal way to go since there is less risk around what might happen with your money. The intuition of the financial advisors I spoke to was accurate in this regard.

But what if you need to save for a big purchase that will take more than two years to reach? Should you change your strategy?

What if You Need to Save Beyond Two Years?

When saving beyond a two-year time horizon, holding your money in cash can be much riskier than it initially seems.

For example, if you wanted to save $60,000 by saving $1,000 a month in cash, we would expect it to take 60 months (five years) in a world with no inflation.

However, when you actually perform this exercise going back to 1926, 50% of the time it would take you 61–66 months (one month to six months longer than you expected) to reach your goal and 15% of the time it would take you 72 months or more (12 months longer than you had hoped).

On average, holding cash takes 67 months to reach the $60,000 goal. Why? Because the longer time horizon increases the impact of inflation on your purchasing power.

Compare this to investing in bonds—where it only takes 60 months, on average, to reach your $60,000 goal.

Since bonds provide some return on your money, they offset the impact of inflation and help to preserve your purchasing power.

More importantly, compared to when we were trying to save up $24,000 over 24 months, trying to save up $60,000 over 60 months is much riskier for cash.

It’s no longer the case that one or two months of extra saving can offset the impact of inflation. Now, on average, it requires of seven months’ additional cash savings to get there.

Yes, there are some scenarios where you can still reach your $60,000 goal in 60 months by holding only cash, but it’s not likely. Because of the longer time horizon, the risk of holding cash is now bigger than the risk of holding bonds.

You can see this more clearly by looking at how many additional months cash requires to reach the same $60,000 savings goal as bonds, as shown in the following chart.

As you can see, in all periods tested, cash underperformed bonds when saving over such a long time horizon.

Does this mean that there is an optimal point at which you should stop saving cash and start saving in bonds? Not exactly, but we can come up with a good guess.

For example, given that a two-year savings time horizon slightly favors cash and a five-year savings time horizon clearly favors bonds, the “switching point” will be somewhere in between. After reviewing the data, I have found that this point seems to be around the three-year mark.

If you need to save for something that will take less than three years, use cash. If you are saving for something that will take longer than three years, put your savings in bonds.

If you had done this throughout history, you would have reached your 36-month savings goal in about 37 months with bonds and 39 months with cash. This is a good rule of thumb that is backed by historical evidence and has worked through periods of high inflation, low inflation, and everything in between.

This now begs the question: Can we do even better than bonds by investing in stocks?

Does Saving in Stocks Beat Saving in Bonds?

Now, let’s look at saving $1,000 a month and investing it in the S&P 500 instead of U.S. Treasury bonds.

How does this strategy fare against bonds? Most of the time it does better, but sometimes it does much, much worse.

For example, if you saved $1,000 a month until you reached $60,000, on average it would take you 60 months if you invested that money in bonds, but only 54 months if you had invested that money in stocks.

The following chart shows the number of months it would take to reach your $60,000 goal throughout history while investing in stocks. For example, if you started investing $1,000 a month into U.S. stocks in 1926, you would have reached $60,000 goal in about 37 months.

However, as you can see in the chart, sometimes it would have taken you much longer to reach your goal. These are the peaks we can see on the chart—some stretching beyond 72 months.

Why is this?

Because investing in stocks during major crashes (e.g., 1929, 1937, 1974, 2000, and 2008) would have meant you needed to save and invest for an additional year (or longer) to reach your savings goal, when compared to investing in bonds.

More importantly, this analysis assumes that you would have been able to invest $1,000 every month regardless of the underlying economic conditions. But this won’t always be the case.

After a major market crash you could lose your job or have other financial needs that prevent you from saving money. This is the risk of using stocks to save up for a larger purchase.

Nevertheless, how you decide to invest your savings for a big purchase doesn’t have to be an all-or-nothing decision. You don’t have to choose between a portfolio of 100% stocks and a portfolio of 100% bonds.

In fact, when saving for a big purchase that is five years away (or more), you can use a balanced portfolio that better fits your timeline and risk profile.

Why Time Horizon is the Most Important Factor

Based on the evidence above, it’s clear that the length of time over which you have to save for a big purchase should help determine how you save for it.

Over shorter periods, cash is king. As a purchase goes further into the future, you have to consider other options. Unless you are willing to pay inflation’s annual toll, you will need to own bonds, and possibly stocks, to allow your money to maintain its purchasing power over time.

Lastly, this analysis assumed that you would save a constant amount over time until you reach a goal. However, as I have mentioned in prior chapters, our finances are rarely so stable.

If you happen to reach your goal earlier than anticipated, then congratulations! You can purchase your big-ticket item immediately.

However, if you need to wait to make the purchase (e.g., a wedding with a fixed future date), then you will need to invest that money in some way to preserve its purchasing power. Unfortunately, that means either forgoing cash in favor of higher-growth options, or saving more cash than you need in anticipation of inflation.

Either way, some areas of personal finance can be more art than science. This is why I recommend that you adapt your strategy based on what investment options you have available to you at the time.

Now that we have looked at how to save for a down payment, we can move on to answering the biggest saving question of them all—when can you retire?

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