How should I allocate short-term assets in a rising-interest rate environment?

Question

I'm looking to rebalance my portfolio and move some of my stock investments into lower-risk investments, largely because I want to use some of it in the not-too-distant future (say 2-3 years). How should I allocate my finances between my Ally bank account, CDs, and the different types of bond fund (short, intermediate, long, and all-inclusive), and stocks?

I'm looking to maximize my return and am willing to take a small degree of risk, but I'm not sure where that is these days. Bonds and CDs are typically great for this, but I'm hesitant to put too much money into them with the likelihood of Fed tapering. Savings is great, but even with my account's relatively high interest rate, I'm concerned that I won't be getting the best return on my investment.

So what I'm thinking now is that the best strategy is diversification between these funds. What's the best way to allocate my short-term money?

Answer 1

How should I allocate short-term assets in a rising-interest rate environment?

Assuming that the last part is correct, there could be bear bond funds that short bonds that could work well as a way to invest. However, bear in that the the "rising-interest rate environment" is part of the basis that may or may not be true in the end as I'm not sure I've seen anything to tell me why rates couldn't stay where they are for another couple of years or more. Long-Term Capital Management would be a cautionary tale before about bonds that had assumptions that backfired when something that wasn't supposed to happen, happened. Thus, while you can say there is "rising-interest rate environment" what else are you prepared to assume and how certain are you of that happening?

An alternate theory here would be that "junk bonds" may do well because the economy has to be heating up for rates to rise and thus the bonds that are priced down so much because of default risk may turn out to not go bust and thus could do well. Course this would carry the "Your mileage may vary" and without a working time machine I couldn't say which funds will be good and which would suck.

As for what I would do if I was dealing with my own money:

Money market funds and CDs would likely be my suggestion for the short-term where I want to prevent principal risk. This is likely what I would do if I believed the rising rate environment is here.