One of the key important factors when investing is the time horizon. Consider time horizon as the date of the investment to the date or dates you need to capture the return on your investment. The return on your investment could be selling the investment for a (hopefully) gain or generating income from the investment as cash flow.
Time horizon will vary depending on the future use of that capital. Here are some examples of needs across different time frames.
Short Term (less than 1 year)
- Money for bills that arrive each week
- Saving for a vacation next year
- Money for college starting next year
- Working capital for a business
Medium Term
- Saving for a down payment on a car/house
- Saving for college
- Saving for a larger vacation
- Investment in business acquisition
Long Term
- Saving for and through retirement
- Longer term saving for college
- Buying a vacation home
For each time horizon, there is a longer time period to invest. This allows for some flexibility in contributions/original investments and the sequence of returns. Flexibility is important but sticking to the plan is key.
Short Time Horizons
The shorter the time period, the more certainty you probably have in meeting the potential need. If you know what your need (expense) is, your original investment amount, and are highly confident of the investment return over that time period, you should have a good idea what your final investment amount will be at the end of the time horizon.
Example: Let’s say you have $10,000 to invest, and you know you need $10,500 for the first year of college. If you are confident you can achieve a 5% total return on a 1-year Treasury note, you should be confident you will have $10,500 in a year. You originally didn’t have enough for the first year of college at $10,000, but by investing, you had an extra $500 for a total of $10,500 for that first year of college.
When you have a short-term need and a short-term time horizon, you should consider taking a more conservative approach. Taking a conservative approach can include trying to match your short time horizon with your investment’s time horizon. In the example above, the you needed to cover a real future expense, the first year of college. It’s an important expense and not meeting the goal ($10,500 in a year) would have been an issue. To take the conservative approach, you invested in a conservative investment (a 1-year U.S. Treasury note) that unless the U.S. government defaulted, you would receive the $500 return.
As you waited for your 1 year investment in the Treasury note, the investment would have some price volatility, but most likely significantly less than an equity investment, for example. Another more conservative option could have been to keep the $10,000 in a checking account or a savings account, which would generally pay less than the return on the Treasury investment. In a traditional checking and savings account, the value of your accounts wouldn’t fluctuate, but the return is less than the Treasury.
Summary: The shorter-term the investment need, the shorter the investment return, the higher need for higher probability of returns, the lower the return, the less volatility of the return.
For short-term investment horizons, consider checking accounts, savings accounts, short-term bonds, short-term bond mutual funds and ETFs. with average maturities that match your time horizon. These options are usually lower volatility lower potential return options. Lower volatility can translate into lower probability of you not achieving your investment target.
Investment Needs: Higher probability of returns with lower volatility. Returns are often lower.
Expanded Time Horizons
As you expand your time horizons, the uncertainty increases, in terms of achieving your goal, the potential returns on your investments and the different types of investments you might want to consider. Time horizon, the volatility of any investment you allocate to and the probability of a return (investment value at sale, income generated) at the end of the time period are so important.
Bonds
Bonds, assuming they don’t default, can be solid investments if their structure allows for a payment at maturity. If you need highly probable income payments over say a 5 year period and your principal back after that 5 year period, bonds are a great asset class to consider.
Equities
Equities, are extremely volatile and shouldn’t be considered for short-term time horizons, in my opinion. Some equities can pay a dividend for income purposes, but those are not generally guaranteed. In addition, if you invest your hard earned money and the equity market declines 40% in a deep recession or some other extraordinary event triggers investors to sell, the value of your investment may be significantly less.
Think about our investor who is saving for college. They had $10,000 to invest and thought the economy was doing well and stocks kept going up. The investor thought it was a “sure thing”. They put $10,000 to try to get the 15% that the equity market returned for the last 3 years, so when college started, with a 15% return, they’d have $11,500, instead of “just” the $500 returned from the 1-year Treasury note. Well, during that year, 6 months before college, a pandemic hit, equities crashed and the investor now has $6,000 instead of the original $10,000. Now the investor can’t afford college next year. Oops.
Real World Example: I had financial advisors that had clients that needed their investment for a short time horizon, I think it was like 1 or 2 years, if I remember correctly. I saw the client’s allocation and couldn’t believe the amount of equity exposure the client had. The financial advisor thought we were in a strong economic environment and that equities “should” keep going up. I thought that was ridiculous. We all know anything can happen and the markets can decline quickly and significantly for any reason. I reminded the advisor that investors need a much longer time horizon (7-10+ years) to invest in equities, not 1 or 2 years. Especially if the client has needs for the capital in a short time period.
In practice, as a portfolio manager, if any advisor needed cash within 1 year, I recommended clients just take their cash out of their investment account and put it in their checking or savings account at the bank. There generally isn’t enough return that compensates the risk of not having that cash for whatever needs the client had. The emotional strain that client would have if the markets declined significantly and they lost that cash that was available, is an emotion that could impact other decisions. Just not worth it in my opinion for any non-professional investor.
Investment Needs: Higher probability of higher returns over longer periods of time, with higher volatility over shorter periods of time.
Investment Style Should Match the Investment Time Horizon
A low volatility, low potential return investment strategy that invests in short-term government bonds is an investment style. There is nothing wrong with this investment style. It serves a purpose, and more appropriately, it is for those that are conservative and/or have a short time horizon for their investment needs.
A higher return and higher volatility strategy that invests heavily in equities is also an investment style. There is also nothing wrong with this investment style. It’s purpose should be to try to generate higher potential returns than other more conservative options. It is a style that should be for investors with longer time horizons that can withstand short-term volatility and higher uncertainty.
Investors can also have a mixture of styles for different time horizons and different goals. An emergency savings account may be held in a liquid savings account at the bank, earning a little bit of interest, while a retirement account may be primarily invested in equities for retirement 20 years away hat may generate average annual returns of 7%.
When investors start to determine which investment style they want to incorporate, they absolutely need to consider their time horizons. If you don’t you may be highly disappointed if you don’t meet your investment objectives.