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Understanding Why Your Time Horizon Matters
Education
In the context of investing, time horizon or investment time horizon refers to the period you expect to be invested before you need the money. The time horizon is closely tied to your life goals. For example, if you plan to buy a house in five years, your time horizon would be around five years. If you are investing for your child's university education in 18 years, your time horizon would be approximately 18 years.
Although it might be tempting for some investors to take on as little risk as possible, this approach may not be optimal for those with a long-term time horizon. Taking on a bit more risk can lead to higher returns over time, which is crucial for achieving long-term financial goals.
Over long periods, riskier asset classes like stocks tend to offer better returns compared to bonds, making them more suitable for long term investment horizons. For example, with a 20-year investment horizon, putting money into ‘risk-free’ cash equivalents can actually be riskier than investing in stocks due to inflation and lower returns. Historically, stocks have outperformed bonds across various time horizons, making them a more attractive option for long-term investors.
Time horizons breakdown
Investment time horizons are categorized into three types: short-term, medium-term and long-term.
Short-term (less than 3 years)
- Examples: Emergency fund, a vacation or a small home renovation.
- Investment strategy: Low risk investment products with lower potential returns, as there’s little time to recover from market downturns.
Medium-term (3 - 10 years)
- Examples: A down payment for a house or the purchase of a car.
- Investment strategy: Moderate risk investment products that offer the potential for capital appreciation but also some portfolio stability.
Long-term (more than 10 years)
- Examples: Retirement savings or a child’s university education.
- Investment strategy: High risk products with higher potential return, as there’s more time to recover from potential losses.
Understanding your time horizon is key to selecting the right strategy to meet your financial goals.
Time horizon, Risk and Asset Classes
The relationship between time horizon, risk and asset classes is crucial, as the time horizon determines the level of risk one should take and the type of assets one should invest in. If your time horizon is long, you can afford to take on more risk and invest in riskier asset classes, as there is more time to recover from potential losses. Conversely, with a short the time horizon, you should take less risk and invest in low risk asset classes to minimize potential losses and ensure access to your capital when needed.
Suitable asset classes by time horizon:
- Short term time horizon: High yield savings accounts, certificates of deposits, money market funds, treasury bills and short-term bonds.
- Medium-term time horizon: a balanced mix of stocks and bonds.
- Long-term time time horizon: Stocks, real estate and commodities.
Rationale for higher risk assets as the time horizon increases
Although it might be tempting for some investors to take on as little risk as possible, this approach may not be optimal for those with a long-term time horizon. Taking on a bit more risk can lead to higher returns over time, which is crucial for achieving long-term financial goals.
Over long periods, riskier asset classes like stocks tend to offer better returns compared to bonds, making them more suitable for long term investment horizons. For example, with a 20-year investment horizon, putting money into ‘risk-free’ cash equivalents can actually be riskier than investing in stocks due to inflation and lower returns. Historically, stocks have outperformed bonds across various time horizons, making them a more attractive option for long-term investors.
See table – Probability of Long-Term Government Bonds Underperforming Stocks
| Probability of Long-Term Government Bonds Outperforming Stocks | |
Time Horizon | Probability |
1 month | 43% |
1 year | 37.5% |
3 years | 30.4% |
5 years | 27.8% |
10 years | 17.1% |
20 years | 8.7% |
| 30 years | 0.8% |
| 40 years | 0.3% |
Even with a time horizon of one month, stocks are more likely to outperform government bonds than underperform. However, when they underperform they are likely to underperform significantly.
See table – Probability of Losing Money while Investing in the S&P 500
Probability of Losing Money While Investing in the S&P 500 | |
Time Horizon | Probability of Loss |
1 day | 46% |
1 week | 43% |
1 month | 38% |
1 year | 26% |
2 years | 18% |
3 years | 15% |
5 years | 11% |
10 years | 7% |
20 years | 0% |