How much time do you have? We’ve all asked this simple question before launching into a rather lengthy story – wanting to ensure that our audience doesn’t depart before we get to the end or at least the best part.
Likewise, financial advisors ask their clients about their time horizon when determining the suitability of certain types of investments – desiring to increase the likelihood of having enough time to realize the future expected return of their investments. Depending on the age, and other specific liquidity needs of the client, that time horizon may range from a few months to years or even multiple decades.
Safer, less volatile investments, which have lower expected returns, are more appropriate for those with a shorter horizon while riskier, more volatile, investments, having a higher expected return, may make more sense for those with a longer term time horizon.
Time, Risk and Return
Defining a time horizon is a crucial part of sound financial planning since not having enough time to see your investments through can have a significantly negative impact on your realized returns.
For example, if you needed all your money in exactly one year, a FDIC insured Certificate of Deposit might be the best option. With a bank CD, you would know exactly how much you’d have at the end of that year, even if it’s just 1% more than what you started with.
However, if you had years or decades to invest, you could consider investing in riskier asset classes (i.e. stocks, real estate, and commodities) where the long term expected return is much higher than the CD. However, the downside is that in the short term the value of your investment is much less certain. If you chose to invest your money in the stock market instead of the CD; at the end of the first year you could potentially end up with half or double your original investment. That’s a lot of uncertainty in a short period of time. If you needed to access your funds at the end of the year, you might be forced to sell at a loss.
Being at the mercy of the stock market’s short term gyrations is never pleasant if you need to sell at bad times to meet short term cash requirements. In the last nine months alone, the S&P 500 has been exceptionally volatile, suffering two double-digit percentage declines.
You can see from the chart above that depending on when you needed your funds, there are better times than others to liquidate your holdings of riskier, volatile investments. Fortunately, the markets have come back from each of the corrections over the last year. However, in a deep, prolonged bear market, a full recovery may take many years. Since these down periods are impossible to predict with any consistency, investors should be prepared to ride out down markets by adjusting their portfolio to meet their expected time frame.
Incorporating both safe and more aggressive investments into a portfolio provides for greater flexibility when drawing down funds to meet both anticipated as well as unanticipated needs. When stocks are down, generating required liquidity from selling bonds or other less volatile investments, which likely retained their value, can make more sense than liquidating fallen stocks. Conversely, when stocks or other riskier asset classes are strong and bonds are weak, selling some stock holdings to meet cash needs may be more practical. The key is to maintain a balance of both elements in a portfolio to match the investor’s needs and expected time horizon. Doing so will give you peace of mind, the ability to stick with your investments, thereby, generating better long term returns from your portfolio.
Hopefully you had the time to read this short article!