A time horizon determines how much time you can expect to hold your investment to get returns on it. Depending on your investment goal and strategies, the time horizon can be for a short time or long-term. Setting a framework around your time horizon is a good exercise for your investment because it contributes to informed decision making. Putting time frames around your investment will set an overview of your financial needs and capabilities, like, whether you need the money in a few years for a down payment or whether you can hold it until you get into college or retirement.
There are no standardised rules on setting your time horizons, and it depends on your financial circumstances and goals. However, there are commonly accepted guidelines to help you determine the appropriate timelines for investments. As such, it is generally agreed that long-term investments require a more aggressive portfolio and can handle riskier investments because the market overall will trend upwards, and you have a lot of time to recover the losses. Your growth would be far more significant if you account for starting early and compounding in your strategy. Short term investments should avoid riskier portfolios due to market volatility.
Here, we will explain time horizons, how you should evaluate them and what risks you should be assuming in different time horizons:
Investments are generally seen in two categories of the asset class: stocks and bonds. Stocks are considered riskier than bonds. Stocks and assets with similar characteristics are considered more ambitious and beneficial for long-term investment. They also tend to grow over a long time and recover from dips pretty quickly. Bonds are preferable for short-term investments for a more conservative portfolio. You should evaluate three simple time horizons to decide on your investment:
All investments have risk, and depending on the time horizon, it manifests differently, which should be adjusted in your strategy. For short-term, the risk manifests rather obviously. The market is volatile and fluctuates very often. Therefore losses are part of the risk. The growth is very small compared to the risk undertaken. Also, the recommendation of short term investments (like bonds and CDs) offer limited and small returns compared to inflation (savings account interest which amounts to less than 1%). It is very straightforward what the risks and rewards are under short term investment.
For the long term, however, the risks are not so straightforward. For example, stocks are recommended for the long term because it moves upwards, also face a rather steep downfall when the market crashes. And such initial loss and that at such a high amount may make you panic, and you want to sell. As an investor, you have to assume both the upward trend and the downward when investing in riskier assets. Not to mention, there can be a slow downfall of assets that may never recover (e.g. oil). In such cases, it might be better to cut your losses and sell everything. On the other hand, you may miss opportunities for significant profits because you choose to stick to long-term investment. For example, selling your stock options to buy a more lucrative asset for higher returns. Such a flaw is not risky per se, but it is a missed opportunity nonetheless.
There is also the illiquidity factor as you cannot access the money when you need it, and if you do, you will lose the progress of your investment. Hence, you will need to keep liquid emergency funds aside.
Aligning the timeline with your investments is one of the most important tasks apart from allocation. Setting a time horizon will give you a basic insight into your financial goals. Although you need to stick to it religiously, it is still better to use it as a spreadsheet to overview your financial situation and opportunities.
Last update: 24/09/2021