Using Investing to Build Up Cash for Large Purchases

Posted on the 22 February 2015 by Smallivy

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My question for you is two-fold; I want to put a down payment on a cheap investment property condo in order to start building equity/credit somewhere, however I live in a very inflated real estate community(Southern California). Therefore I have looked into a condo in the 125-150,000 range. What is the most logical strategy for a goal of 20% down on a condo running in the 125,0000-150,0000 range? PMI is a bad word to me.

Over long periods of time, investing is the only way to go. In addition, you'll do a lot better investing in equities (stocks) than you will in virtually any other type of investment. This is because companies grow and expand, becoming more valuable with time so they are actually worth more, while also seeing an increase in price per share due to inflation. Long term returns on stocks after inflation are in the range of 4-8%, versus maybe 2-4% for bonds. In real estate, some individual properties will do well because they are in a geographical area that suddenly becomes hot and there is some natural increase in demand as populations grow and fight for a limited number of properties, but you also have the decline in the value of the strictures as they rot and need to be maintained, plus the constant drag of property taxes.

That said, using equities to raise money for something only a few years out is fairly risky. For example, go and look at the annualized returns for the S&P 500, which is an index containing 500 large, brand-name stocks. Since 1970, over a 1-year period the median return is almost 16%, meaning that there were as many years with a return better than 16% as there were with one less than 16%, but the returns ranged from about +38% to -37%. If you only invested for a year in an index, you have about equal chances of making or losing money, and you could lose about 40% of the amount you invest in a really bad year. Investing in individual stocks for a year has even greater volatility. Over periods of five or ten years your chances of having a negative return during that time frame go almost to zero (and they would go to zero if you invested monthly during those years rather than put all of your money in at the start of the five years). For periods of 15 years or more, there were no instances where you would have had a negative return and returns ranged from about +8-9% to +17% or more annualized. Note that the 20 and 25 year return ranges are almost equal, meaning that 20 years is enough time for most of the volatility in returns to settle out.

So the point here is that trying to invest for something 3-5 years out when you really need the money after that 4 years is a bad idea. Unfortunately, the only way to be almost certain of having the money at the end of that period of time would be to work and save it up, settling for the pitiful returns of bank CDs and money markets. But in your case this would mean making an extra $30,000-$40,000 per year that you could save, which obviously would be very difficult for most people. It could be done, however, by taking extra jobs and finding extra sources of income. This would take a huge toll on your body and your relationships and isn't something you would want to do for very long, but if you absolutely needed the money it would either mean doing that kind of sacrifice or putting the purchase off. This is also assuming that you couldn't grow your income quickly in your primary job, which isn't something that should be overlooked. In fact, if you are able to put in extra hours at your primary job and get paid for them, you might find yourself with a promotion because of those extra hours and the value you're bringing to your employer. Looking for ways to train and grow skills is also a path to consider.

In your case, however, you'd like to have the money in a few years, but it isn't an absolute necessity. If things didn't work out you could put it off for a few years and just buy the investment property a little later. You may therefore be able to use investing to help you out. The difference is that, instead of absolutely needing to have the money in four years, your requirement to have the money in that period of time is less stringent, meaning that the consequences of not making the date are less severe. It would be nice to have the money in 3-4 years, but if it was five or six, or even eight of nine years, that would also be OK. Because the stock market tends to have great years after bad years, and because the tendency of the market over long periods of time is always up, there will almost certainly be a time in the future when you will have the money you need if you invest enough and do so regularly.

You can think of this as being opportunistic, sort of like with hunting. You may sit in a tree stand all day and not see a thing. Other days you may see the buck of your life and be able to fill your freezer with meat for months. If you absolutely need the meat on any given day, you are taking a huge risk by hunting for it and you may well go home hungry. If you instead don't really need to harvest a deer on any given day, however, and are able to wait around, if you wait for a suitable period of time there will likely be an opportunity to get one. You might even get more than one during some periods. You just need to wait for that opportunity.

If this is the case and you can be opportunistic, I would just grow my portfolio in the standard way - by investing regularly either in two or three low-cost diversified index funds or in a set of individual stocks that I felt were well-run and had a lot of room to grow. In this case investing in funds would be the better option since you would be limiting losses that might set you well back and you would have a better chance of the economy in general growing over a period of a few years than you would in picking individual stocks that would do well over such a short period of time. You could also use a hybrid approach and have a base of funds and a few individual stocks. If the stocks do well, you could sell some shares and add to your mutual fund portfolio, perhaps reaching your goal more quickly.

Just to get a feel for the kind of money you would need to be putting away, you could assume a return of between 10% and 15% and use a financial calculator to determine about how much you would need to invest each month to reach your goal in 3-4 years. Realize, however, that your actual returns will not be consistent from year to year. You might see greater returns in some years and lower returns or even negative returns in others. The 10-15% is just a guess at an average return based on past performance of the markets. You just need to hope for a couple of really good years to augment what you're earning and putting away to get you to your goal more quickly. Unfortunately, if I do that calculation I see that you would need to save something like $1800 a month even with a 15% return to reach the range you're targeting in four years.

Seeing that, I think you would need to look at a more realistic time frame. A 10 year period with a 15% average return would get you there with about a $400 per month investment. You could also work to see how you can raise your income, both by learning new skills and raising your salary at your main job and by doing odd jobs and finding other sources of income along the way. Given your interest in real estate, you might look at things such as putting in the sweat equity for someone who is buying houses, fixing them up, and then reselling them. Perhaps you could get a good cut of the profits there if you managed the rebuild while your partner provided the cash. You could also look into getting a real estate license and selling homes on the side. This would both allow you to increase your income with evening and weekend work and learn the area, which would help with your future investments.

Finally, remember that if you use investing to raise cash that you'll need to include taxes in figuring up how much you'll need to raise since you'll incur federal capital gains taxes when you sell. You state also has high taxes which will take a bite out of your investment money, especially since you'll incur a large gain for the year when you sell to put the money into the investment property.

I really wish you the best of luck and hope you make your first million before you reach 40. Keep up the great work!

Got a question about investing?  Leave a comment or write me atvtsioriginal@yahoo.com .
Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.