Time is valuable
A marathon is 42.2 kilometers or 26.2 miles. If we offered you $1 million to complete a marathon on foot, would you take us up on the challenge? What if the caveat was that you had to do so in less than two hours and fifteen minutes? It’s possible, but a very small percentage of the population is capable of doing so. What if we gave you a month do so? Most people can and do walk 1.5 kilometers a day, which means you could complete the marathon in a little over 28 days.
How much time do you have?
An investment time horizon is just a fancy way of saying how much time you need to reach a financial goal. If need money to pay tuition for your child in five years, your investment time horizon for that particular goal is five years. If you are saving for a vacation in six months, your investment time horizon is six months.
Risk is time horizon dependent
The longer your time horizon the more risk you can afford to take. The shorter your time horizon the less risk you can afford to take. Stocks are a relatively risky asset. On any given day they have roughly a 50% chance of losing money and a 50% chance of gaining money. Let’s consider the S&P 500, which is a U.S. large-cap stock index.
See table – Probability of Losing Money While Investing in the S&P 500
The probability of losing money over one day is 46% but drops to 26% over one year and 7% over 10 years. The S&P 500 has never lost money over a 20-year period of time. It is very risky to invest in stocks if your time horizon is one day, but it isn’t if your time horizon is 20 years.
Time horizon and asset classes
You should choose different asset classes for different investment time horizons. An investment time horizon of zero to two years is considered very short. Very low risk assets like savings accounts, certificates of deposit and high-quality short-term government bills are typically recommended. With a two-to-five-year time horizon, it makes sense to introduce longer-term government bonds, corporate bonds and maybe a very small percentage of stocks. With a five-to-ten-year time horizon, it makes sense to tilt more heavily towards stocks. Finally, with a time horizon greater than ten years you might tilt even more heavily or completely towards stocks.
Low risk assets become higher risk assets as the time horizon increases
With longer and longer time horizons it actually becomes riskier to invest in the assets that are considered less risky. With enough time, you will be compensated for taking on this risk. If your time horizon is 20 years, it is riskier to invest in a “risk-free” cash equivalent than it is to invest in stocks because you will almost certainly be better off investing in stocks. Consider bonds vs. stocks over different time horizons.
See table – Probability of Long-Term Government Bonds Underperforming Stocks
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. With longer time horizons, the opposite is true. Stocks almost always outperform bonds, and, when they do, they outperform significantly.
Probability of Losing Money While Investing in the S&P 500
Probability of Loss
|Probability of Long-Term Government Bonds Outperforming Stocks|