In a general sense, short term investments are what you buy but don’t expect to keep for very long, whereas long term investments are what you might hold forever. But where do you draw the line? For most companies and many individuals, investments bought and sold within a year count as short term, and assets held for more than a year are considered long term, but the exact time frame might be different for everyone.
1. What are Short Term Investments?
Short term investments are made with the expectation to cash out within a relatively short period of time. Financial instruments that could be sold within a year of purchase include short term papers and marketable securities.
Short term papers include US Treasury securities and commercial paper.There are four types of US Treasury securities, treasury bills (T-bills), notes (T-notes), treasury inflation-protected securities (TIPS) and bonds (T-bonds). They have the full backing of the US government and therefore are considered virtually risk free. Extra sense of security usually means lower returns, compared to commercial paper for example. By purchasing US Treasury securities, you are lending money to the US government for a specific period of time. T-bills have the shortest maturities and offer the lowest yields of the four. Unlike T-notes, TIPS and T-bonds, T-bills mature within a year and therefore are considered short term investment. Although all four belong to the category of US Treasury Securities, they are not considered the same kind of investment in this blog.
Commercial paper is issued by blue chip corporations to pay off their own short term debt and usually matures within a year. Compared to US Treasury securities, commercial paper is not backed by a collateral and therefore generally riskier, although default on high quality commercial paper has been rare. Only companies with excellent credit ratings from recognized credit rating agencies can issue commercial paper at a reasonable price. Even though it’s a short term obligation, commercial paper can be issued as part of a continuous longer rolling program.
Marketable securities are defined as unrestricted financial instruments that can be bought or sold on a public stock exchange or a public bond exchange. It’s a requirement that there is a strong secondary market, which reflects accurate prices, to facilitate transactions easily and quickly. They are either marketable equity securities (i.e. common or preferred stocks issued by public companies) or marketable debt securities (i.e. short term bonds issued by public companies).
2. What are Long Term Investments?
3. What is Market Liquidity?
Market liquidity is the trade-off between the speed of transaction and the asset price. Higher liquidity means more readily traded or converted to cash without significantly influencing the asset price. Cash and savings accounts would be considered the most liquid. The degree of market liquidity is the main difference between short and long term investments. Since short term investments are expected to be sold within a year or sooner, they need to be able to find new buyers more easily and quickly than long term investments. However, each individual investor has a different risk profile.
There are situations where an investor might choose to hold a liquid asset for a long period of time, or rush to sell an asset that usually doesn’t change hands very often. For example, someone with low risk tolerance might feel safer holding cash or savings in a bank account instead of investing in stocks or bonds. On the other hand, someone in financial distress or an emergency situation might need to sell off real estate at 30% discount to the market price.
While many people buy and sell stocks within a year, a month, a day, or even minutes, others like Warren Buffett prefers to hold his favorite companies for as long as he can. While personal preferences don’t affect the fundamental liquidity of the assets, oftentimes they have greater influence on investment decisions.
4. Which Should You Choose?
Market liquidity is valuable, so higher liquidity usually means lower returns. Assume you are interested in buying US Treasury securities and you’re given two choices: 1 year maturity with a yield of 0.5% and 30 year maturity with a yield of 2.5%. Which one would you choose?
You might consider a number of things, including your overall view of the markets, expected investment returns from other assets, and whether you can afford to have some capital locked up for a long period of time. If you believe that this is a difficult year for other types of investment (such as stocks, commodities and currencies), then the 1 year US Treasury security might offer some capital protection for the current year. If you don’t monitor the markets and don’t expect to use the money in the near term, then having 30 year US Treasury security in your portfolio would probably give you peace of mind.
For the purpose of diversification, private investors like to have a variety of asset types in their personal portfolios. Short term investments can be readily sold or converted to cash. Long term investments can save time, lower transaction cost and sometimes enjoy extra tax benefits. What does your portfolio look like? What is your preferred ratio of short term vs long term investments?
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