Dear Dagen: I'm Buying a House in Five Years; Where Should I Stash My Cash Until Then?

With that time frame, you might want to avoid equities. A look at bond options.
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I'll be selling a rental property this summer and plan to put the $10,000 in proceeds plus $500 per month toward a vacation home that will be purchased or built in about five years. We're planning an early retirement in nine years and will be moving to the vacation home. We have a good mix of stock mutual funds (growth and value, small and large, plus international), real estate and cash in money market accounts. I'm thinking of going with a low-cost Vanguard fund, either the (VBINX) - Get Report Balanced Index or the (VBMFX) - Get Report Bond Index fund. Is there a better alternative? We have a small portion of a retirement account in bond investments, so I thought the Bond Index may be a good conservative move to balance a fairly aggressive portfolio of about $500,000. -- Rodney Lau

Rodney,

Unless you're willing to consider the thatched-roof look (a la

Gilligan's Island

), you should keep that money out of the stock market.

Your situation dovetails with a basic rule of investing, one that I've repeated often: If you need the money in five years or less, don't buy stocks.

But you still have to put it somewhere. If not stocks, then bonds.

First, you have to choose between buying individual bonds and a bond fund. When buying individual bonds, you will almost certainly get your full principal back when the bond matures -- assuming that the issuer doesn't default. With a bond fund, on the other hand, there is no guarantee that the fund's shares will be worth as much when you sell them as when you bought them.

Still, in your situation, a bond fund may be the sensible choice. Building a portfolio of non-Treasury securities can require a sizeable amount of money. Your initial $10,000 investment probably isn't enough to buy individual bonds at a good price (except Treasuries bought at auction through

TreasuryDirect). And the $500 monthly installments definitely cannot be invested in individual bonds easily.

With bond funds (just as with equity funds), you can get extensive diversification by investing a small amount of money. And since you are planning to make relatively small, monthly contributions to this savings plan, a fund will be an infinitely easier option.

If you have a definite target date of five years, that's clearly long enough so that you can bypass short-term bond funds or money-market funds. By investing in funds that hold investment-grade, intermediate-term instruments, you should earn a higher return than you would in shorter-term securities while taking on a level of interest-rate risk that you should be able to handle given your five-year time period.

A general rule to follow: Buy a bond fund whose average maturity closely matches the time you have to invest. Long-term bond funds typically yield more, but the funds' net asset values, or NAVs, are more volatile than the NAVs of short-term funds. In an intermediate-term fund, you will probably get more price fluctuations than in a shorter-term funds, but with five years to invest that should be bearable. Plus, the extra return will be worth it. If you are willing to leave some of this money on the table, you can go with a short-term instrument. Or as you get closer to your target date (say two years away), you may want to withdraw some assets from your intermediate-term investment and put the money in a short-term instrument or a money market fund.

Once you know the term, you then have to decide exactly what type of bond fund to buy. Some financial planners suggest an intermediate-term, investment-grade corporate bond fund. With a corporate bond fund, you are taking on credit risk, which you won't get with Treasuries, but you can pick up good incremental yield. And the NAV may actually fluctuate less in the corporate fund.

Since you mentioned Vanguard, I took a look at the firm's offerings. The firm, indeed, has an

(VFICX) - Get Report

Intermediate-Term Corporate fund. The current yield on this fund is 6.4% compared with 5.46% for the firm's

(VFITX) - Get Report

Intermediate-Term Treasury fund. The fund's expense ratio is also a low 0.27%, not a surprise for Vanguard.

As always, this is merely a suggestion. You may also want to take a look at the Vanguard's

(VBIIX) - Get Report

Intermediate-Term Bond Index fund or the

(VWITX) - Get Report

Intermediate-Term Tax-Exempt fund. If you are in a high tax bracket, the tax-exempt fund is certainly worth examination.

There are two things we haven't addressed. First, how much money you will need to build or buy this vacation home? Taking this investment route may not deliver enough money to buy a house in full but will hopefully provide a nice down payment. And perhaps you are a more aggressive investor than the above guidance would suggest and

can

tolerate some equities, say in a balanced fund as you mentioned.

Personally, that's a place I would fear to tread.

For a complete tutorial on bonds, read Elizabeth Roy's

Bonds Primer or send your bond questions to

fixed-incomeforum@thestreet.com.

Send your mutual fund or personal finance questions, along with your full name, to me at

deardagen@thestreet.com.

Dear Dagen aims to provide general fund information. Under no circumstances does the information in this column represent a recommendation to buy or sell funds or other securities.