When contemplating an investment, few questions are as important as "What is your time horizon?" The answer can help you decide what type of investment vehicle you should consider, which investments to avoid and how long to hold your investment before selling.
Risk and Time
Investors often put their money into an aggressive investment vehicle, such as stocks or gold, and then let time pass without taking any action. While the investment may be a good choice when purchased, it can become less and less appropriate as time passes. Saving for retirement is one area where this result can be clearly seen in a variety of scenarios.
In one common example, investors purchase stock in their employer for their entire career. Over the course of several decades, biweekly payroll deductions and an employer match help the employee build up a substantial number of shares in the company. As the employee’s retirement date approaches, the stock market crashes, devastating the value of the employee’s portfolio and forcing her/him to continue working.
A similar result is often seen when an employee puts 100% of his or her savings into equity mutual funds. Over time the balance grows, but as the employee’s retirement date grows near, a decline in the stock market wipes out a substantial portion of the employee’s nest egg.
College savings is yet another area where an investment plan can be sidetracked by an unexpected market decline.
These scenarios play out frequently. In response, the financial services industry has created investment products to help investors match their portfolio holdings to an appropriate time line. This approach helps investors avoid the negative outcomes associated with inappropriate asset allocation.
Of course, with any of these investments, one must pay attention to associated fees and costs. Some mutual funds and investment products such as target date funds charge higher fees than others, so expenses must be taken into account when considering the time frame of your investment.
Evaluating Time Horizons
There are no hard-and-fast rules, but some generally agreed-upon guidelines will help you decide which investments are appropriate for various time lines.
To create a portfolio based on time, you must realize that volatility is a bigger risk short term than long term. If you have 30 years to reach a goal, such as retirement, market volatility that causes the value of your investment to plunge may not be an immediate danger given that you have decades to recover. Experiencing the same volatility a year before you retire can derail your plans.
Accordingly, placing parameters around the time frame of your investments is a valuable exercise.
- Short Term
As a general rule, short-term goals are those less than five years in the future. With a short-term horizon, if a drop in the market occurs, the date on which the money will be needed will be too close for the portfolio to have enough time to recover from the market drop. To reduce the risk of loss, holding the investment in cash or cash-like vehicles is likely the most appropriate strategy. Money market funds and short-term certificates of deposit are popular conservative investments, as are savings accounts.
- Intermediate Term
Intermediate-term goals are those five to 10 years in the future. At this range, some exposure to stocks and bonds will help grow the initial investment's value, and the amount of time until the money must be spent is far enough in the future to permit a degree of volatility. Balanced mutual funds, which include a mix of stocks and bonds, are popular investments for intermediate-term goals.
- Long-Term Time Horizon
Long-term goals are those more than 10 years in the future. More conservative investors may cite 15 years as the time horizon for long-term goals. Over long-term time periods, stocks offer greater potential rewards. While they also entail greater risk, there is more time available to recover from loss.
To help investors avoid the negative consequences associated with bad timing, the financial services industry has created a variety of investments designed to address the challenge.
- Target-Date Funds
Target-date funds are mutual funds that automatically reset the mix of assets (stocks, bonds, cash) in their portfolios according to a selected time frame. They are frequently used as retirement savings vehicles, with the mix of investments becoming more conservative as the investor’s retirement date approaches. For example, a target-date fund designed to fund an investor’s retirement 30 years from today might have a mix of investments weighted heavily toward stocks with a moderate amount of bonds and little cash. Thirty years later, the mix might be the exact opposite, with cash making up the largest percentage of the portfolio followed by a moderate amount of bonds and few stocks.
- College Savings Plans
Qualified tuition programs, also known as 529 plans, help investors cover the cost of a college education. Named after Section 529 of the Internal Revenue Code, these tax-advantaged programs help investors pay the costs of tuition, room and board, books and other costs associated with a college education. Similar to predicting the year in which an investor is eligible to retire, it is easy to determine the age at which a child will be headed to college. Through 529 plans, investors have two ways to plan in advance for the expense.
One method is a college savings plan that permits investors to set aside a specific amount of money that is generally invested in a pre-approved list of mutual funds. Many of these funds are age-based funds, which operate in a similar manner to target-date funds. As the child ages and the date on which tuition must be paid approaches, the asset allocation becomes more conservative. Since the value of the investment portfolio changes with fluctuations of the financial markets, automatic adjustments to the portfolio move money to more conservative investments to reduce the risk that a stock market crash will wipe out the savings just before tuition comes due. The challenge here is that underlying investment growth may not be enough to cover the full tuition cost.
Investors who have a lump cash sum that can be invested and are concerned about market fluctuations have another option. This method is known as a prepaid plan. A prepaid plan enables investors to purchase future semesters of college at today’s price. The prepayment guarantees the beneficiary’s tuition in the future regardless of the actual cost. By paying in advance, investors get a lower price and eliminate the need to worry about fluctuation in the financial markets hurting their ability to meet tuition costs.
- Mutual Funds
Choosing investments that automatically shift assets to a more conservative investment strategy isn’t the only option for investors seeking to invest using time horizons. Investing in mutual funds and then moving the money to less-aggressive funds as time passes is another option. So-called “balanced” funds even offer a balance between stocks and bonds in a single fund.
Mutual funds are a convenient way to diversify. They offer professional investment management, including security selection, and a large variety of choices, making it easy to get a mix of many securities, including both stocks and bonds.
- Stocks and Bonds
If you have the time, skill and interest, you can build and manage your own portfolio. As time passes, you can adjust your asset allocation in favor of less-aggressive investments.
The Bottom Line
Time-horizon investing is all about planning. You need to think about your goals. Once you have done that, investment selection is based on the amount of time you have until the goal must be funded. As the funding date approaches, assets are shifted to move conservative investments to reduce the risk of market-related losses derailing your strategy. However, associated fees need to be considered when choosing the mix of investments.
More From Investopedia
- Personal Finance - Career & Education
- Investing Education
- mutual funds