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 give you 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.
What is an investment time horizon?
The question "what is time horizon" has many answers, but none too different. A time horizon may refer to the length of time you want to keep an asset until selling it. A time horizon can also refer to the time it takes you to reach a savings goal, such as a pension. The time horizon is significant since it determines how much you need to save or spend to achieve a specific objective. Depending on your age and progress toward your goal, your investment may have a long time horizon, spanning several months to decades. Saving for a down payment on a house, for example, would be considered a short-term time investment, but investing time horizon for retirement would be considered long-term investment horizon. Therefore, your investment time horizon strategies should be set according to individual financial circumstances.
Understanding investment time horizons
There are no standardised rules for setting your time horizons as you need to understand your time horizon when investing. Your goal time horizon depends on your individual circumstances. However, there are commonly accepted guidelines to help you determine the appropriate timelines for investments. As such, it is generally agreed that long investment horizon 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 accounted for starting early and compounding in your strategy. Due to market volatility, short term horizon investments should avoid riskier portfolios.
Here, we will explain time horizons, how you should evaluate them, and what risks you should assume in different time horizons:
- Good investments for short time horizons
- Example of an investment time horizon
- Investment horizon and risk
- Why time horizons matter in investing
- How to determine your time horizon
- How to evaluate your investments according to time horizon
Good investments for short time horizons
Investments with a short-term horizon are those that are intended to endure less than five years. These investments are suitable for people nearing retirement or who may require a large sum of money in the near future. Investors with a short-term time horizon investment are often more cautious in order to minimise market dangers. Because these low-risk instruments may not have enough time to recoup from losses caused by a volatile market, stability is the goal. Saving for a car, a trip, or a down payment on a house are just a few examples.
If you have a narrow time horizon, it suggests you have a few things working against you. To begin with, you don't have a lot of time to develop your money. Second, if the market drops, the dates on which the money is needed will be too close together for the portfolio to recover its losses in time. Money market funds (fixed income mutual funds that invest in debt instruments with short maturities and low credit risk), savings accounts, certificates of deposit, and short-term bonds are all attractive short-term investments since they may be liquidated quickly for cash. You can also invest in lower-risk items like buyback agreements or promissory notes. Stocks should be avoided in general.
Example of an investment time horizon
For instance, if you are a student who is currently reliant on student loans to cover your tuition and other college expenses. While you are currently living in a dorm, you would like to have your own place by the time you complete your degree, which generally takes 2-3 years. As a result, you'll need to start saving for things like rental deposits, school debt payments, and living expenses in the city. You also need the time to seek decent employment while covering these fees. This is an example of a short-term investment horizon, with the goal of remaining fiscally prudent.
When you do find a job, your own place, and have all of your financials in order, you will need to consider your employment or voluntary pensions. And, because you are still young, you have a long way to go. That is an illustration of a long-term time horizon investing. As a result, you can afford to make riskier bets with your money, allocating more to stocks and less to bonds.
Of course, you ultimately find someone with whom you want to settle down. You two intend to marry in roughly 5 years. Because weddings are costly, you should begin saving for them as soon as possible. This is an illustration of a medium-term horizon.
Investment horizon and risk
All investments have risk, and depending on the time horizon, it manifests differently. This should be adjusted in your strategy. In the 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) offers 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 in short term investment.
For the long term, however, the risks are not so straightforward. For example, stocks are recommended for the long term investment horizon because they move upwards, but they also face a rather steep downfall when the market crashes. And such an initial loss, and at such a high amount, may make you panic, and want to sell. As an investor, you have to assume both the upward trend and the downward trend 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.
Why time horizons matter in investing
Failure to align one's investments with one's time horizon might result in failure to attain whatever goal one wants to achieve when investing. The time horizon is significant since it determines how much you need to save or spend to achieve a specific objective. Your risk tolerance is intimately tied to your time horizon, which is determined by how much you need and how soon you need it. Both long term and short term strategies need to be included in your financial plan.
Investors with longer time horizons are more likely to take on more risk. This is because the market can rebound from a downturn over a longer period of time. For example, if an investor has a 35-year time horizon, his or her portfolio is more likely to contain equities than bonds, like mid and small stocks and alternative investments. Short-term volatility in these instruments is substantially higher than in large-cap equities. This is because mid-cap and small-cap equities are less well-established and so more susceptible to external economic forces.
As their time horizon shortens, most investors make changes to their portfolios. Investors may choose to hold more cash and fixed-income instruments and fewer shares as they approach retirement to reduce their risk exposure. Fixed-income investments tend to reduce risk by yielding lower returns over longer periods but with less volatility and price swings, resulting in greater portfolio stability.
Investors with a longer time horizon are frequently more aggressive, favouring high-risk, high-reward investments. This is because they will have more time to recuperate from any bear markets. Investors with a short-term time perspective, on the other hand, are often more conservative. Stability is the goal because these low-risk instruments may not have enough time to recoup from losses caused by a volatile market.
How to determine your time horizon
Choosing a time horizon is quite straightforward for most people, but for investors, it can be quite tricky. Savings and making large purchases simply require a person to save consistently. However, for investors, it is not so easy because there are external market factors that may impact your investment. Nevertheless, the most obvious tool for establishing your temporal horizon is your age. Your age can help you determine how long to hold an investment and which assets are best for you. Depending on your age, you may need to repay educational loans or medical bills so you can identify potential investment prospects and set financial goals alongside your financial duties.
Start by creating a time chart from your starting age (for investment) to your retirement. This will assist you in determining your longest time horizon. From there, you may start filling in various financial goals that require different time frames.
Now that you have a roadmap for your financial goals, decide how you will achieve them. You must consider both your first investments and ongoing donations as they will assist you in compounding the investment capital. Your ongoing contributions are a component of the road map that will get you there. The amount you contribute can help you either accelerate or slow down the time it takes you to reach your goals.
Another factor to consider is your way of life and how you spend your money. Controlling your expenses and spending patterns can help you achieve your financial goals early. Because you'll be reliant on your retirement income to meet living expenses for years, your life expectancy is a crucial consideration for your savings strategy and goals.
How to evaluate your investments according to time horizon
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 two simple time horizons to decide on your investment:
- Short term: generally lasts less than 5 years, short term investment requires a more critical approach to prevent any unfortunate losses from sudden market dips and ensure that there is enough time to recover within a short time even when the market falls. Bonds, short term deposits, and high yield savings accounts are popular since they can be liquidated when needed. Generally, people nearing retirement tend to rely on these because they will need the cash very soon, or investors who need the money for a big purchase (a house, e.g.)
- Long term: Long term goals are those that last more than 5 years and can last forever. Depending on the goal, the aim is to get some exposure on your investment to grow until retirement and allow volatility to work in your favour. Long term goals can be for retirement, children's future or their education. Funds and stocks should be the primary investment choices since they provide great benefits in the long run. Long term strategies will strike a balance between risk and rewards with a mixture of assets growing your money and protecting it from inflation. An ideal investment choice would be target-date funds, along with mutual funds and a mixture of stocks and bonds. Target-date funds are mutual funds that automatically reset asset allocation (between stocks, bonds, and cash) as time passes. The fund will start with an aggressive portfolio only to switch its focus to a more conservative portfolio as you near your retirement date
Summary
Time horizons can refer to the amount of time an asset is held or the amount of time it takes to attain a financial goal. There are no defined guidelines for determining your time horizons. There are, however, widely established criteria that might assist you in determining the proper investment timeline. Long-term investments are thought to necessitate a more aggressive portfolio and the ability to withstand risky bets because the market will normally trend upwards and you will have plenty of time to recover your losses. Short-term investments should minimise riskier portfolios due to market volatility. Short-term investments include fixed income mutual funds, bank deposits, certificates of deposit, and short-term bonds. Risk exists in all investments, and it presents itself in different ways depending on the time horizon. This technique should be adjusted accordingly.
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.