Good investment advice often extols the importance of having a long-term time horizon. But, as sensible as the idea sounds, it is complicated by the fact that ‘long term’ means different things to different people and, when emotions come into play, it may mean different things to the same person, depending on the day.
An advisor will frequently ask investors to specify their ‘investment horizon’ (usually by ticking an option of three, five, or seven years). They then use this information to help determine a level of risk for the portfolio. But despite the important role it plays in portfolio design, there is no real consensus on what an investor’s ‘time horizon’ really means, and it remains one of the most misunderstood concepts in finance.
First, let’s look at what the investment horizon is not.
- When thinking about your overall portfolio, your time horizon should not be how long you’re prepared to stick with any single investment or manager. When making a specific investment, you may quite reasonably resolve to leave funds in for, say, three years. This, however, is an evaluation horizon, it doesn’t affect the appropriate risk levels for your portfolio and is not the length of time over which you should be considering your overall investment strategy.
- An investment horizon is distinct from your rebalancing horizon: we should all periodically rebalance our portfolio back to our appropriate risk level, but this is quite distinct from the horizon of the portfolio as a whole, and shouldn’t be used to determine appropriate risk levels.
- It is not (or is only rarely) the same as the time to retirement – many investors still have capacity to invest post retirement and should not be entirely in cash. Why stop taking investment risks at 65 when you may well have three decades or more of life left? (The exception here, just made less likely by the recent budget, is when you need, or want, to annuitize a large portion of your wealth at retirement. In this situation, your investment horizon is strongly linked to your retirement date.)
Put simply, your investment horizon should be determined by when you need the money: when will you need to make capital withdrawals, and how large might they be? Before this point you get to choose when to sell, and so have the option to sell only when markets are high, rather than low. Your investment horizon reflects how long you’ve got, on average, before this option expires.
Many wealthy investors are in the fortunate position of being able to fund their lifestyle using income from external sources – their time horizon, therefore, is almost* infinite. In fact, many investors do not even see death as the termination of their investment goals since they would like to leave continually growing capital to their descendents. Arguably, after retirement investors gradually have more capacity to take risk as they have ever-decreasing future expenditure to fund.
Most investors, however, have interim needs to withdraw capital – either to fund large purchases, school fees, or ongoing expenditure after retirement that cannot be funded from income. These investors have finite investment horizons. Future withdrawals – unfunded by expected income – will reduce the time horizon. The closer these future withdrawals come, the shorter your average time horizon; and the larger they are as a proportion of your wealth, the more they reduce your average time horizon.
For example, someone who is retiring in three years and wishes to purchase an annuity with his entire portfolio has a definite time horizon of three years. He has very little option to choose when to sell and therefore should take very limited risk in the intervening years. On the other hand, an investor who can afford to stay invested at retirement has a long sequence of much smaller withdrawals over the rest of her life. Her immediate exposure to market risks is considerably smaller because her average time horizon is much longer – most portfolio withdrawals will happen well after this three-year point. She can afford to take more risk in the pursuit of higher portfolio values over time.
As a general rule, asking investors to tick a box for a specific horizon without carefully considering their future needs for the money is counter-productive – it often forces them to state an investment horizon that is shorter than their true goals, and this is counter to all good advice on investing as a long-term activity.
In addition, we need to be aware of one more horizon – the emotional horizon. Selling low because you need the money can be resolved by reducing risk over time to account for your shortening horizon; but many investors sell low even when they still have the option to hold on. In times of stress, our emotional horizon shrinks. Good investing requires not just determining our investment time horizon, but also controlling our emotional one. Make sure you have the financial, and emotional, liquidity to choose when you sell.
* We have to account for the possibility of unexpected expenditures, which should constrain our risk taking to some degree. However, many of these possibilities (illness; loss of income; large expenses incurred through accidental damage or theft; etc.) are more effectively and cheaply contained using insurance than by incorporating them into the notion of investment horizon.