Using mutual funds and ETFs for short-term savings (1 year)

(Title will be:

Using mutual funds and ETFs for short-term savings (1 year)

and it will be one of a set of articles showing results for 6 months, 1 year, 2 years, and 5 years.)

=Introduction= In investing, we make personal choices about how much risk we are willing to take if we think we can get higher return in exchange. An important element of risk is volatility, which is often measured in terms of standard deviation (σ). It is not, however, directly relevant to questions like "how much risk I am taking if I put money I will need for a near into a bond fund instead of a money market fund?"

Here, we calculate some other measures of risk by calculating what would have happened to an investment of $10,000, held for short periods of time, in a mutual fund or ETF. You might do this in hope of making more than you would have made in a money market mutual fund, and accepting the possibility of sometimes making less. The possibility of making less is depicted in two ways:

1) What percentage of the time would you have made less than in a money market fund? We chose VMMXX, the Vanguard Prime Money Market Fund, because it is one of the oldest money market fund and gave us a long period of comparison. We also show what percentage of the time you would have actually lost money--ended up with less than $10,000 at the end of the time period--and what percentage of time you would have failed to keep up with inflation.

2) It's important to know not just when a fund or ETF underperformed a money market mutual fund, but by how much. In the case of short-term funds, the losses, when they did occur, were so small that some might call them negligible To quantify this, we present two numbers. One is the average loss that occurred in those periods in which losses did occur; and the other is the largest loss that ever occurred within the body of data that was used.

Notice that a high probability of underperforming may not be important at all. If two investments have the same return and volatility, but just fluctuate randomly with respect to each other, you would expect each of them to underperform the other about 50% of the time.

We have chosen to present data going back for as far as Morningstar has data. As a result, there are two caveats. First, the data range shown for each fund is different and results for different funds cannot be directly compared. For example, the Vanguard Short-Term Treasury Fund, VFISX, beat VMMXX by an average of $117.10 while the Vanguard Short-Term Treasury Index fund, VGSH, only beat it by $33.17. But this is almost entirely due to VGSH's inception in 2009 versus VFISX's inception in 1991. If we restrict our view of VFISX to the same years as VGSH, the benefit for VFISX was only $44.05. Second, this underlines the problem with all historical data, which is that the present time--and thus the short-term future--may be quite different from the historical averages.

=Data=