Investment Horizon

What is Investment Horizon?

Investment horizon refers to an investor's duration to hold an asset before expecting a return. It can range from short-term (days/weeks) to long-term (years/decades), influencing investment strategies and risk tolerance.

Every investor wants their assets to increase over time, so they can eventually use that money to buy something or enable them to retire. As we know, every investor has different motivations for investing. Some of the most common reasons for investing are:

• Retirement
• Beat inflation
• Reach a financial goal like buying a home, starting a business, or funding education
• Reduce taxable income
• Get in early by investing in a start-up company

The investment you choose and how much you attribute to that asset depends primarily on your time horizon. The investment horizon is the total time you expect to hold an asset.

Generally, older investors tend to invest their cash in more conservative assets with less risk. This is because they are more likely to need the money soon, and periods of significant volatility can devastate their portfolios. 

Younger individuals tend to have a longer investment horizon and invest in riskier investments to earn higher returns potentially. Funding for the long term makes periods of volatility less detrimental to your portfolio, as there is more time to recover from losses.

Your age and the target date of your financial goals affect your investing horizon.

Types of Investment Horizons

Before investing, consider how long you plan to hold investments. The investment horizon impacts the performance of various asset classes. Time plays a crucial role in the performance of stocks, bonds, mutual funds, ETFs, and other types of investments. 

There are three general types of horizons:

1. Short-term
2. Medium-term
3. Long-term

Investors may engage with multiple time horizons, but individuals at different life stages may prioritize certain time ranges. For example, older people will likely be focused on short—and medium-term horizons.

Typically, the longer the horizon, the more risk you are willing to take because you will likely not require access to your funds anytime soon. However, this is not always the case.

Short-Term

This includes people who have short-term financial goals, such as buying a car. Many individuals may invest a portion of their savings for short-term goals in bonds or low-risk investments to earn higher returns than a traditional savings account.

Examples of short-term goals include:

• Car payment
• Wedding
• Gap year travel

While often safer, short-term investments tend to have lower yields. They are usually intended to maintain the value of the original investment rather than produce high returns.

Some examples of safer investments for short-term time frames are:

• Money market funds
• Certificates of deposit
• Short-term bonds

Liquidity is also necessary with short-term investing to allow easy access to your money. For instance, let's say you are saving money for a down payment on a car in one year. You know you will need the money, so you want to ensure your investment doesn't lose value.

One option could be to put the cash in a short-term certificate of deposit. This would allow you to earn a higher interest rate on your deposit but with minimized risk.

An example of asset allocation for the short term is:

• 70% cash
• 20% bonds
• 10% stocks

Medium-Term

Medium-term time horizons typically span five to ten years, indicating a timeframe for investors to hold their securities before considering selling. This includes individuals who are less risk-averse and do not have specific long-term plans for their investment. 

Examples of medium-term goals include:

• House down payment
• Children's education
• Home Remodel

Medium-term investors are in the middle of being conservative and aggressive. As a result, they tend to have portfolios with a mix of stocks and bonds to provide higher returns and reduce risk. This mix of securities will protect you from significant losses.

Additionally, exchange-traded funds (ETFs) can be a valuable asset for medium-term investors because they have the potential for higher returns but come with less risk than stocks.

For instance, you have a child who will need tuition in nine years. With the extended period, you can afford some risk, but you should be cautious because you cannot afford to lose a significant portion of your investment

One option is to invest in a mix of stocks and bonds. Asset allocation for the medium term is influenced by factors including investment goals, time horizons, risk tolerance, target amounts, and prevailing market conditions.

An example of asset allocation for the medium term is:

• 10% cash
• 40% bonds
• 50% stocks

Long-Term

Due to their extended investment horizon, long-term investors are often more tolerant of risk, potentially allowing them to benefit from the growth of securities over time. As a result, shorter periods of volatility are often irrelevant over long periods.

Long-term investing has a horizon longer than ten years. Many people begin saving for retirement early in life. They invest this money instead of putting it in a savings account because they will not need access anytime soon.

Examples of long-term goals include:

• Retirement
• Children's education
• Starting a business

While long-term investing may involve more risk, it also offers the potential for greater returns, depending on the specific assets and market conditions. In addition, long-term investments make sense for young people who can invest cash they will not need soon.

Due to compounding, time can be your biggest ally in investing. Compounding enables your investment to grow exponentially, and investing early in life can pay big dividends.

An example of asset allocation for the long-term is:

• 90% stocks
• 10% bonds

Investment Horizon and Risk

There is always some risk associated with investing, especially in stocks. Below are a few of the most common threats your investments may be exposed to:

• Inflationary risk: Inflationary risk refers to the possibility that inflation is higher than the returns on your investments. This causes the actual value of the asset to decline. Bonds are particularly susceptible to these risks.
• Interest rate risk: Interest rate risk concerns unexpected changes in interest rates. This is primarily a concern for bonds and other fixed-income securities. This risk can be reduced by holding bonds of various durations.
  
• Business risk: Business risk refers to the possibility of a company failing or declaring bankruptcy. This causes your assets to lose value, possibly becoming worthless. The most effective method to reduce exposure to this risk is to maintain a diversified portfolio.
• Market risk: Like business risk, market risk acknowledges the stock market's volatility. Large-scale events, speculative behavior, and market crashes can all affect the value of your investments. This risk is typically more relevant for short—and medium-term horizons because, over a long period, investments are more likely to increase in value.
• Default risk: Default risk is the likelihood that a borrower cannot repay their debts. It is particularly relevant to debt-based securities such as bonds. Investing in bonds with higher credit ratings can limit this risk.

Example of Investment Horizon

Let's say you recently graduated from college and have lived in an apartment in the city for two years. At twenty-four, you are looking to move into a home in a local suburb with your partner, whom you've been with for years.

You have finished paying off your student loans but plan on getting a used car within the next six months. You have a little over half of the cost saved up but need to figure out where to put the cash from your savings account to earn more Interest. 

In this case, purchasing a car is a short-term horizon, so you want to look for something conservative but with a higher yield than your current savings account, which only pays 0.75%. So you decide to put the money into a 6-month certificate of deposit with an APY of 1.85%. 

Next, you want to make a down payment on a house in 6 years but still need to generate more cash.

You invest 60% of the cash into funds like the Vanguard S&P 500 ETF (VOO) and the Vanguard Dividend Appreciation ETF (VIG). You notice that VOO's historical performance over the past five years has been 12.5%, and VIG's has been 12.4%.

You are comfortable with the safety of these investments and understand there is a slight possibility that the assets will lose value. Therefore, to diversify your portfolio, you also put 30% of your cash into a high-yield bond index, such as the Vanguard High-Yield Corporate Fund (VWEHX).

The remaining 10% of the cash is kept in your traditional savings account as a safety net if you have to renew your lease in a few years because the other securities lost value. 

Additionally, you plan to marry your partner soon and understand that the wedding will be expensive. Depending on when you get married, this could be a short—or medium-term goal.

Because you are uncertain when you will get married, you decide to invest 40% in stocks, 30% in bonds, and 30% in a high-yield savings account. Meanwhile, you are already beginning to plan for retirement because you are a knowledgeable investor and understand your investment horizon.

You do not plan on retiring for at least thirty-five years, so you devote 90% of your portfolio to stocks to maximize potential returns. Given that you do not need the money anytime soon, you are comfortable with a portfolio of primarily stock risk. 

Investment Horizon And Asset Allocation

Your asset allocation determines how much risk you subject yourself to. For example, investors with long-term horizons are likely to invest more heavily in stocks, while short-term investors often have more bonds.

This is a suggestion on asset allocation by age, but your allocation depends on your financial situation and investing profile.

As you age, your portfolio may require rebalancing to maintain your desired asset allocation and ensure it aligns with your risk tolerance.

Diversification is the key to providing a balance of potential risk and return. Diversifying your portfolio limits your asset-specific risk, so if one company or sector underperforms, your portfolio doesn't lose all its value.

Your asset allocation should change as you age and your investment horizon adapts.

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Active Bond Portfolio Management
• Asset Management Company (AMC)
• Box Spread
• Capital Preservation
• Equity Market