Takeaways
- An investment’s time horizon is the length of time you own an investment.
- Investment time horizons are grouped into three categories: short, medium, and long.
- Longer investment time horizons allow more time for the power of compounding interest.
- Longer investment time horizons lend to investors having more aggressive portfolio allocations.
Every investment you make can have an explicit or unspecified time frame. That time frame might be specific, such as putting capital into a savings account for a vacation, buying a home, or preparing for a comfortable retirement. Alternatively, it can be unspecified, like investing in a stock. Think of the time horizon as your relationship with that investment. Understanding the concept of an investment’s time horizon is crucial for creating an effective investment strategy, allocating assets wisely, and working in line with your risk tolerance.
Let’s analyze the concept of an investment’s time horizon, what exactly that means, and why it matters. We will also explore how it relates to an investment’s risk so that you can make the most informed decisions about your portfolio.
What is an Investment’s Time Horizon?
An investment’s time horizon refers to the day, months, or years you plan to hold an investment before needing access to your capital1. The time horizon is the period from the initial investment transaction until you aim to liquidate the asset for a specific financial goal.
Your time horizon can be as short as a few months (checking accounts, money market funds, certificates of deposits) or extend over many decades (target date funds, index funds, or 15-year mortgages), depending on your financial objectives. Understanding your investment time horizon is essential as it influences your risk tolerance, the types of investments you choose, and your overall investment strategy.
Why is Time Horizon Important?
Understanding the time horizon of your investment goals, as well as the time horizons of individual investments, is critical to shaping an effective financial strategy. Here are five areas where time horizons come into play:
1. Risk Management
Longer time horizons will let you take on more risk since you will have more time to weather market shifts. However, these investments can tie up capital for extended periods. For example, if you are retirement planning, deciding to invest in your Roth IRA or 401(k) plan for retirement is a long-term investment strategy. Investments made for retirement should have a long-term time horizon.
Smart Money -> Everything You Need to Know About Target Date Funds
2. Investment Selection
Your personal time horizon will influence the types of investments suitable for your portfolio. Your comfort with how far into the future you want to deploy capital is a major component of investment selection. For example, you may want to develop a bond ladder that takes advantage of short-term interest rates during periods of high inflation.
Smart Money -> What is the Federal Reserve?
3. Financial Goals Alignment
Identifying your time horizon helps align your investment strategy with your financial goals, no matter what those goals are. Finance professionals advocate for developing short-term and long-term goals. Ideally, a well-diversified portfolio has the proper mixture of investments with varying risk, capital allocation, time horizons, and asset classes.
Smart Money -> How to Achieve Financial Independence Now
4. Performance Expectations
Knowing your time horizon also helps set realistic expectations regarding investment returns. For example, if you invest in a high-risk startup company, you should expect that you might not earn a return on that investment for several years. However, if you invest in a high-yielding dividend stock you should expect an immediate return in the form of dividend payments.
Smart Money -> What Are Dividend Reinvestment Plans (DRIPS)?
5. Tax Impact
Your investment time horizon can have tax implications, affecting the timing and amount of capital gains taxes. Tax treatment depends on how your investments are categorized:
Short-Term Capital Gains: Short-term capital gains are taxed at your ordinary income tax rate.
Long-Term Capital Gains: Long-term capital gains have favorable tax treatment and are taxed at your ordinary income tax rate. Long-term capital gains rates vary from 0-20%.
Tax Rules: The IRS has specific rules on how certain investments are taxed based on their classification. For example, real estate investments have tax advantages over simple stock investments, while high-yielding dividend stocks have the added component of dividend income. Consult a tax professional for tax advice.
3 Types of Time Horizons
The length of your investment time horizon often falls into one of three categories: short, medium, or long-term. Each one has unique benefits and drawbacks. Let’s examine each category:
Short-Term Investments
With terms ranging from only a matter of days to less than five years, short-term investment horizons are ideal for meeting shorter-term financial objectives and for those who want to be more conservative with their investments. You can use these investments to save for an emergency fund or slush fund, achieve financial goals like saving for a down payment on a house or car, or invest during the final years leading up to retirement.
Length: 1 Day – 5 Years
Examples: Savings Accounts, Checking Accounts, Certificates of Deposits, Stocks, and Bonds
Mid-Term Investments
Medium-term horizons, those investments you intend to hold between 5 and 10 years, might cater to goals like buying a house, saving for college, or a marriage fund. A balanced mix of assets like bonds, stocks, or mutual funds can provide more aggressive growth while managing risk. Mixing the asset classes you invest in during the medium-term investment horizon will help boost investment returns while maintaining diversification.
Length: 5 – 10 Years
Examples: Mutual Funds, Index Funds, Long-Term Bonds, Stocks and Private Investments
Long-Term Investments
Long-term horizons are typically aligned with retirement savings or long-term wealth accumulation. They allow for more aggressive investment strategies, focusing on stocks, real estate, or other growth-oriented assets to maximize potential returns over the long run. Longer-term investment horizons allow you to deploy capital to take on timeline risk and increase your rewards.
Length: +10 Years
Examples: Mutual Funds, Index Funds, Long-Term Bonds, and Stocks
Time Horizon and Risk
As mentioned earlier with risk management, there is a complex interplay between an investment’s time horizon and its inherent risk. Learning more about this interplay will help you add significant prowess to your financial and investment planning and give you the insight to make an investment portfolio with the proper allocation of stocks, bonds, and other investments that marry with your risk tolerance, financial goals, and investment time horizon. Below is more information on how risk and time horizon are linked.
Asset Allocation
Your time horizon will guide how you allocate your assets among the assorted investment vehicles and financial instruments. Longer horizons favor more volatile but potentially higher-return assets like stocks.
Risk Tolerance
Longer time horizons allow for higher risk tolerance since you’ll have more time to recover from a potential downturn. Allocating the right amount of your portfolio to riskier long-term investments will help spur growth.
Market Volatility
Shorter time horizons may require more conservative approaches, or additional hedging, to avoid capital erosion due to turbulent market conditions. Longer horizons give you more time to deal with market swings but lock up investment capital for an extended period.
Risk Mitigation
As the investment time horizon shrinks, increased risk mitigation becomes critical. Reallocating to lower-risk assets, such as high-yield savings accounts, can help preserve capital as you get closer to realizing gains or liquidating investments.
Investment Strategy Adjustment
As your time horizon changes, so too should your investment strategy. With less time until you reach your financial goal, you should be considering transitioning to lower-risk assets. If you are new to investing, consider starting with these 10 investment strategies for beginners.
Smart Summary
Constructing the perfect investment portfolio can be an elusive goal for many investors because goals and needs are dynamic. Personal finance experts advocate that the best strategy is to find the right balance of risk and reward, which aligns with your financial goals. You can then calibrate asset allocation, with varying degrees of time horizons, whether it is short-term investments like CDs and bonds or longer-term investments like stocks and mutual funds. Understanding how an investment’s time horizon fits into your overall financial strategy is a smart money move.
(1) U.S. Securities and Exchange Commission. Time Horizon. Last Accessed November 3, 3023
