What is your time horizon and why is it important?
A time horizon is a way of assessing your risk tolerance or ability to take risks as an investor. At its core, a time horizon provides the answer to a crucial question: When do you need this money?
Example time horizon
An investment goal that almost everyone shares is a comfortable retirement. The normal retirement age is 67, but let’s say you want to retire a little earlier, at 65. If you are 30 years old in 2022, your time horizon is 35 years to 2057. Earlier in your career, you will need to take greater risks with your investments in order to accelerate your growth and be comfortable enough to fill the workforce in 2057 to leave.
However, when you’re thinking about retirement, it’s important to realize that you need to think about a different time horizon. You don’t need all the money on retirement day. Depending on your health and family history, your money may need to last you for about 30 more years. Bankrate’s retirement calculator can be a helpful resource for understanding how long those retirement savings can last.
Common time horizons
Because you have multiple goals for your money, you will be thinking about a number of different investment horizons at the same time. From preparing to buy a new car to planning to buy a vacation home, you need to assess each of your goals in terms of the calendar. Here are three common time horizons.
Short term time horizon
A short-term time horizon refers to money that you need to access soon. An example of a super-short horizon is your emergency fund, which you can park in a high-yield savings or money market account.
If an unexpected worst-case scenario happens tomorrow, you need your money immediately to cover some expenses. There are other financial needs that fit the short-term horizon category, albeit with a slightly more distant horizon.
If you’re saving for a down payment on a house, you may want to reach your goal before your rental expires in 11 months. They can’t afford to lose value, but some extra growth would certainly help. Perhaps put the money in a short-term certificate of deposit to take advantage of any increase in interest income.
Medium-term time horizon
What fits into a medium-term time horizon may vary depending on how you look at your goals, but these are typically between five and 10 years away.
For example, if you’re saving for college for your 10-year-old, you’ll need to withdraw money for college tuition over the next eight years. With a longer lead time, you can accept some risk tolerance, but you’ll likely have a mix of investments that won’t expose you to large losses. For example, you could diversify your investments between stocks and lower-risk bonds.
Long term time horizon
When you think of big goals that are further from the present, you are acting in a long-term time horizon. As a younger investor, retirement is the most obvious example of a long-term horizon.
If you’re in your 20s or 30s, you have decades of work ahead of you. The longer you have, the more you can afford to manage the risk of downside in your investment portfolio.
Why it is so important to understand your time horizon
Knowing your time horizon is essential to outlining an investment strategy that meets your goals. The time horizon dictates a very important distinction: the rate of return from Your investment versus return on your investment. With a shorter time horizon, your focus is tilted toward returning from it; You want to make sure you get back your original investment. For example, if you know you’ll need the money next year, you don’t have much time to grow it — and you don’t have much leeway to lose it.
However, if your time horizon is longer, you will think about the common definition of ROI: a return on your money. The luxury of the extra time allows you to tolerate more volatility in order to generate higher returns.
This is how you determine your investment horizon
Understanding your investment horizon starts with determining when you need that money. Bankrate’s simple savings calculator can give you an idea of how much you would need to save over that time, at an average annual rate of return, to get what you need.
Remember that as your time horizon changes, your investment allocations will change. As the date you need your money gets closer on the calendar, you need to take a more conservative approach. At 25, for example, your retirement has a long-term horizon. At 60, the money you need to draw in the first few years of retirement is invested for the short term. You will focus less on growth and more on avoiding losses.
