Not every investor is the same, and we all have different goals and approaches in the way that we manage our money and investments. This affects not only the investments we choose but also how long we hold them. This is why investment horizon is such an important concept to understand and apply to your investment portfolio.
What is an investment horizon?
An investment horizon or investment time horizon is defined by the period that you intend to hold your investments until you have to sell and use the money. While most investors simply invest without ever planning when to cash out, knowing your investment horizon allows you to choose more suitable investments that align with your goals and strategy.
Having a well-defined investment horizon is also helpful in determining the best strategy and investment approach to achieve your financial goals.
How an investment horizon works
When you start investing, you have a goal in mind, either you want to generate additional to buy a car, for example, or a downpayment for a house. Every investor is different, and they have different goals, strategies, and ways to achieve them.
Knowing your investment horizon allows you to plan and strategize your investments in a way that makes it easy to achieve your goals. It also helps investors choose appropriate assets for their investment horizon, strategy, and goals.
Additionally, some other factors may also influence your investment horizon, such as your age, your experience investing, and your risk profile.
Example of investment horizon
Let’s consider a 25 years old investor named Mark that has money saved up that he wants to invest. Mark will not need to cash out his investments for a long time and is willing to take on additional risks. This type of investor with this profile is able to invest for the long term, therefore having a long investment horizon. Due to its age and the fact that it will not need the money right away, Mark can invest in riskier assets, such as stocks, and hold them for many years.
Now let’s consider another investor named Jane, which is saving for a downpayment on the house. Jane wants to buy her house in the next five years, so her investment horizon is short. Therefore Jane has to choose investments with a low-risk profile to guarantee that when she needs the money for the downpayment, she will not experience any losses. For these reasons, Jane should invest in bonds, which are less volatile than stocks, and if the maturity is within those 5 years of investment horizon, she will get the principal back.
Importance of investment horizon
Defining your investment horizon is an essential step for a successful investing journey because it forces you to have well-defined goals and plan your investments based on them. It also ensures that you choose suitable investments for your goals, and risk profile, that align with your situation.
Another reason why your investment horizon is essential is the fact that it allows you to adjust your returns based on your individual goals.
Investment horizon and returns
Understanding the relationship between an investment horizon and returns is also essential. For the most part, returns are correlated with risk, and the more risk you take, the more likely you are to generate higher returns.
Considering these facts, an investor with a long-term investment horizon can generate, on average higher returns, because it invests in assets with more risks that can generate higher returns and can hold them for an extended time.
Investors with shorter investment horizons cannot invest in risky assets, so they invest in safer options. Safer investments will have lower returns, but at the same time, the likelihood of losing money will be far smaller.
Types of investment horizon
There are 3 main types of investment horizons, short-term, medium-term, and long-term.
Short-term investment horizon
A short-term investment horizon can be a few months or up to 5 years. This is suitable for investors who will need to use the money in the short term for a large purchase like a house. Traders also have a short-term horizon, and some may even day trade.
An investor may also choose to invest part of their portfolio in short-term investments to ensure that he has enough cash in case something unexpected happens.
Investments suitable for short-term investment horizon:
- Certificates of deposit
- Defensive stocks
Medium-term investment horizon
Investors with a medium-term investment horizon can take significantly more risk than those with a short-term one. Medium-term usually represents 5 to 10 years, and suitable investments include stocks, both growth, and value, as well as some bonds.
With a 5 to 10 years investment horizon, investors can take on additional risk and have more time to wait in case their investments decline in price. However, you want to avoid taking many risks and investing in highly volatile assets that may decline in price by the time you decide to cash out.
Long-term investment horizon
A long-term investment horizon is usually above 10 years of holding period, bringing many advantages to investors. You can invest in many riskier assets, such as small-cap stocks or high-growth companies. The reason is that you have enough time to hold on to your investments without feeling pressured to sell.
You can also deal with the ups and downs, and the longer investment horizon gives you more time for your investments to compound. It is also possible to take advantage of retirement investment accounts such as a 401k or a Roth IRA, which could help you save on taxes and boost your returns.
How to determine your investment horizon
The simplest way to determine your investment horizon is by asking yourself a few questions. These questions will help you determine the level of risk you should be taking and the holding period for your investments.
When do you need the money back?
First and foremost, you need to know precisely when you will need your money back. If you are planning on using the money you invest in a certain timeframe or a specific date, this allows you to determine straight away what your investment horizon should be,
For example, if you are investing for the next 10 years and the funds will be part of your retirement, you can have a longer time horizon, allowing you to take on additional risk. You can invest in riskier stocks that might generate above-average returns.
If you are planning on using the money in fewer than 5 years, you want to make sure that you do not take additional risks and limit the amount of money you may lose. f you have a considerable expense coming up, like buying a house, or a car, or even sending your kids to college, you might want to protect your principal.
What investment strategy are you going to use?
Not every investor is the same, and there are far too many approaches to investing. Some people hold stocks for decades, and others hold them for just a few hours. Knowing the strategy, you want to employ will also help you determine your investment horizon.
To generate short-term gains by trading, you must adapt your predefined investment horizon to that strategy. Conversely, if you want to use a buy-and-hold forever approach, you need a longer investment horizon.
How old are you?
Another crucial factor in helping you determine your investment horizon is your age. The older you get, the more you should worry about capital preservation. If you are younger, you can take on additional risk and have a longer investment horizon.
If you are older, your investment horizon is shorter, so you must be more risk-averse when picking your investments. This affects not only the type of assets you invest in but also your investment horizon.
What is your risk profile?
Investors differ in the way that they can tolerate risk, and this affects the investments they make as well as their investment horizon. An investor unable to tolerate risk and short-term losses should have a longer investment horizon to withstand the volatility.
On the other hand, an investor with more tolerance to risk can invest in riskier assets with a shorter investment horizon. Adapting your investment horizon to your risk profile ensures that you do not panic if your investments decline in value and avoid making emotional investment mistakes like panic selling.
What are your investment goals?
Finally, your investment goals should also influence your investment horizon. If you set high investment goals, you must have a long enough investment horizon to ensure you can achieve them. It will also require you to take additional risks, which are more suited for investors that invest for the long term.
Why having a long-term investment horizon is important
Being a long-term investor has a lot of benefits that are important to be aware of. On the one hand, you can take on more risk and potentially achieve higher returns. On the other hand, you also have more time to achieve your investment goals and deal with any short-term losses or setbacks.
Additionally, a long-term investment period can help you deal with and fix any investing mistakes you make along the way. Making it easy to implement slight changes or adapt your strategy.
Here are some of the main benefits of having a long-term investment horizon:
Mistakes can be corrected
Investors make mistakes, and that is as natural as anything else in life. Mistakes can be costly and difficult to correct when you have a short investment horizon. But when you have a more extended investment period, you can make mistakes and slowly correct them.
For example, if you buy an overvalued stock, the price might decline in the short term. This will affect an investor with a shorter investment horizon more than a long-term investor. A long-term investor can simply average down on that same stock and lower its cost basis since it intends to hold the stock for the long term. An investor with a short investment horizon that makes a mistake can be very costly.
Stocks tend to go up over the long term, and the longer your investment horizon, the more likely your stock portfolio will be worth more. In the short term, you may experience a stock market crash or a bear market, and this can disproportionately affect your returns in the short term.
However, if you invest for a more extended period, your portfolio will likely go up over time. This significantly reduces the risk of losing money or having lower returns.
Compounding allows investors to achieve higher returns over the long term, and the longer your investment horizon, the easier it will be to compound the value of your investments. An investor with a 5-year investment horizon will not be able to compound the value of their portfolio at the same rate as an investor with a 20-year investment period. Therefore, a long investment horizon gives you a much higher compounding effect.
What is a good investment horizon?
Determining what a good investment horizon is dependent on the type of investor you are, your financial goals, and your financial situation. It is crucial to keep in mind that defining your investment horizon should be carefully planned and organized according to your goals, needs, and your current financial situation.
Not every investor is the same, and we all have different goals. Therefore, this can influence how your portfolio should be built in a way that matches the amount of risk you are willing to take and that allows you to achieve your financial goals.