March 1, 2018
March 1, 2018
There’s no doubt about it, the stock market has been behaving beautifully in the past eight years. The market has gone up almost predictably in each of those years, with barely a 10% decline happening at any point along the way. At this point, it can very much look like a sure thing. But be warned, the only investment that’s a sure thing is a true sure thing. And that’s not what stocks are, and that’s what makes them a risky place to save for your down payment.
The most obvious reason why you might want to save for your down payment in stocks is the opportunity to grow your savings through investment earnings.
We’ve all seen those charts that show that if you save X amount of money each year, for Y number of years, with an average annual rate of return of N, that you can build a small fortune for your retirement.
The thinking then, is that if you can do this for a large, long-term goal, such as retirement, the same thing can be done with shorter-term goals, such as saving for the down payment on a house.
On some level, it certainly makes sense. For example, if you can save $5,000 per year for five years, then you can accumulate $25,000. But if you can follow the same savings pattern – and invest the money in the stock market at an average annual rate of return of 7% – at the end of five years you’ll have nearly $30,000.
That would give you a nice nest egg to put down on a house, and either provide you with a larger down payment for a larger home or leave you with extra cash after closing.
That sounds like a solid plan – IF you can steadily achieve the 7% annual rate of return. And that’s the problem.
While it is entirely possible that the investment scenario could turn out exactly the way you hope, there’s no way to guarantee that will be the case.
There are at least four scenarios that could unravel your plan:
The market could go against you. A general stock market decline will not only prevent you from getting the hoped-for return on your investment, but it can also leave you with less money than what you started with. Even if you are invested fairly conservatively, such as with index funds, a 20% overall decline in the market over the next five years can leave you with 20% less money for your down payment. That would leave you in an even worse position than if you never invested the money at all.
One or more of your stock positions could take a hit. Even if the general market goes up, you could be holding one or more stock positions that don’t pan out. For example, it’s entirely possible that a stock can go from say $50 a share, down to $5 a share. Even if only 10% of your savings were held in one stock, it would result in a decline of nearly 10% of your entire down payment savings.
The market could turn against a sector you’re invested in. The same situation could occur if instead of holding individual stocks, you held index funds. Even if the general market rises in value, or doesn’t decline, it’s possible that you could be holding positions in one or two sectors that underperform the market. For example, if you put 20% of your money into an energy index fund, that fund loses 50% of its value, then your down payment savings will decline by 10% overall.
Your investment time horizon is short. Let’s get back to those retirement projections for a minute. The basic reason that they work is that they are usually applied over several decades. All average returns are just that – averages. There’s no guarantee that you will get 7% on your money or any other desired return. Though that may apply over 20 or 30 years, it’s entirely possible that you could experience a decline in the short run.
The fundamental problem with using stocks for short-term savings goals is that you will not have time to recover short-term losses. For example, if you are planning to save a down payment for the purchase of a house in five years, but your investments take a serious hit in years two and three, there won’t be enough time for you to recover those losses before you need the money to purchase the desired home.
Up to this point, we’ve been talking about a five-year time horizon, which is considerably longer than what most people allocate for accumulating a down payment. More likely, your time horizon will be only two or three years. And if that’s the case, you’ll have even less time to work with.
As reliable as the stock market may be over the long run, it can be notoriously unpredictable in the short run. Though you may need the stock market to rise steadily and predictably over the next few years to grow your down payment, the market may go in an entirely different direction.
This is when it’s important to realize that investing in the stock market isn’t like investing in bank assets. There is no promise to pay a certain rate of return, nor even a guarantee that the principal amount of your investment will be protected.
If you are using stocks to save and grow your down payment, there is a very real possibility that you will end up with less money than you actually saved. For this reason, unless your savings time horizon is very long, as in at least 10 years, your best strategy is to avoid stocks entirely as a vehicle to invest your down payment money in.
Since saving money for the down payment on a house is both a relatively short term goal, and one with a very specific purpose, you are far better off investing money in guaranteed investments. That’s the only way to be certain that the money will actually be there for the specific purpose when you need it.
For this reason, your preferred investments should be the type that both guarantee your principle and pay a predictable rate of return. This can include certificates of deposit, money market funds, and even US Treasury securities with maturities of not more than five years (or whatever the expected date of the home purchase will be).
When it comes to short-term goals, such as saving for the down payment on a house, it’s best not to chase return. There is an inverse relationship between return and risk: the higher the potential return on the investment is, the greater the risk of loss will be.
Don’t let a protracted bull market in stocks lull you into thinking that stocks are a safe way to grow your money for short-term goals. That certainly is true over the short run, and that’s why it doesn’t pay to take chances. While you’re busy trying to use stocks to increase your down payment savings, there’s a very real possibility that you can lose a big chunk of your savings. That might put a serious cramp in your home buying plans.