Considerations for holding short-term reserves?
About 20% of my income comes in at the beginning of each year from being a business owner. For the past few years, I've been keeping reserves needed to hold me over to the next year in a money market account.
However, I've been thinking that given that the this income is relatively predictable, I'd probably be better off putting it in a taxable investment account and including the allocations as the rest of my long-term portfolio. My thinking is that I can take long-term risks because even though the balance fluctuates between 100% at the beginning of the year and close to zero by the end of the year, it does so every year.
If I do treat this as part of my regular long-term, well-diversified investment portfolio's asset allocation, what investments make the most sense to keep in this account, knowing that most of the funds will be liquidated over the course of each year? Remember that my risk tolerance is high and long-term, so that shouldn't be a factor.
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Factors to consider:
Until you exhaust all of your tax-deferred opportunities like 401ks, HSAs, FSAs, etc. you should put as little into taxable accounts as absolutely possible.
For the taxable investments:
If you purchase a stock fund and hold on to it for less than a year, you'll be taxed at your marginal tax rate on any gains.
You can withdraw funds from stocks that haven't appreciated at any time without penalty.
You could keep the stocks in a margin account and use the margin cash until the stocks have been held for a year, but of course the (deductible) margin interest will eat at your gains.
With bonds, you're guaranteed to have taxable income at the marginal tax rate. That's probably a better investment to hold in tax-deferred accounts.
It is a dangerous policy not to have a balance across the terms of assets.
Short term reserves should remain in short term investments because they are most likely needed in the short term. The amount can be shaved according to the probability of their respective needs, but long term asset variance usually exceed the probability of needing to use reserves.
For example, replacing one month bonds paying essentially nothing with stocks that should be expected to return 9% will expose oneself to a possible sudden 50% loss. If cash is indeed so abundant that reserves can be doubled, this policy can be expected to be stable; however, cash is normally scarce. It is a risky policy to place reserves that have a 20% chance of being 100% liquidated into investments that have a 20% chance of declining by approximately 50% just for a chance of an extra 9% annual return.
Financial stability should always be of primary concern with rate of return secondary only after stability has been reasonably assured.
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