Investor time horizon and risk tolerance are frequently overlooked when we think of investing. Rather, I frequently get questioned about general market outlook. People are very concerned about the market as a whole and how their individual investments stack up.
In reality, however, “the market” is a huge and complex beast. Some investments have a lot of risk while others are more conservative. When investing it is important to compare apples to apples.
To do this you must first begin with exploring your own personal situation. What is your tolerance for risk? How soon will you need the money? What are your financial objectives? None of us will answer these questions identically. So we must consider what is right for us rather than what is the “best” investment.
Start with your Time-frame
Before asking “what should I invest in?” each person should be asking “should this money be invested?” Investing involves risk. Along with the possibility of making money is the possibility of losing money. And the shorter one’s time frame, the less likelihood that there will be time to earn back any money that is lost. Therefore, a shorter time horizon means a greater risk to your principle investment.
Some common rules of thumb for investment time frames are as follows*:
- 11+ years – A long time horizon
- 6-10 years – A medium time horizon
- 3-5 years – A short time horizon for a portfolio containing equities (stocks)
- 2-3 years – A short time horizon in which a stock and bond portfolio may be appropriate
- 0-2 years – A very short time horizon in which cash may be most appropriate
*These are general guidelines provided for reference and are not intended as individual investment advice. Multiple factors should be considered when selecting an investment, not just time horizon.
Long Time Horizons
You have likely noticed that many of the investment options in retirement accounts are stock mutual funds. This is because those investing for retirement are often saving for a time at least 11 years in the future. Historically, stocks have outpaced the growth of bonds or cash over longer time horizons. There is a potential higher reward for investing in equities that may be appropriate for a longer term investor.
Short Time Horizons
Often I speak with clients who have money set aside for a major upcoming expense like a new home or education. They worry that they money is sitting in the bank earning next to nothing. Investing that money in the stock market, however, would be putting it at risk. As we saw in 2022, someone who invested their money in January is likely to have lost a portion of it by June and even more by year end. When money has been targeted to cover a specific, near term expense, the opportunity cost of not earning large investment returns is knowing the money will be available when the bill comes due.
Cash investments can be a good option for those with a short time horizon and/or those looking for very low volatility. These are investments in which the investor earns interest that is calculated as a percentage of their principle investment.
Two common cash investment vehicles are certificates of deposit and money market funds. In both CDs and Money Markets, an investor will most likely receive back their principle investment plus will earn interest or dividends on that investment. There is no such thing as a risk free investment, but CDs and Money Markets have some of the lowest risk of any investment. Because the risk to principle (meaning the risk of getting back less than the amount you invested) is quite low, the earnings are also likely to be lower. The trade off to taking less risk with your money is that you are settling for a lower rate of return.
Though admittedly a bit dry, I am including below a brief summary of each of these investment vehicles.
Certificate of Deposit
A certificate of deposit (CD) is an investment vehicle that is purchase through a bank. You invest a set amount of money for a specific duration of time at a predetermined interest rate. You know that at the end of the time period you will have your initial investment plus the interest earned. If you need to withdraw your money early, then you will forfeit some or all of the interest earned. But you will still receive back your initial investment. Since banks are insured by the FDIC, there is very little risk to your principle investment.
Risks of a CD:
- Your money is tied up for a set amount of time. If you have an unanticipated need for the money you may sacrifice some or all of your earnings in order to gain access to your principle investment.
- Limited earnings potential. A CD pays a predetermined interest rate which may be lower than you could potentially earn in other investments.
Money Market Funds
A money market fund is a type of mutual fund that invests in highly liquid investments such as cash and cash equivalent securities. Money market funds generally trade at $1 per share. The share price is not guaranteed, but there are very few times, historically, that money market funds “broke the buck”, or traded at a price below $1 per share.
Rather than investing for capital appreciation (price increase), money market funds pay dividends. The dividend earnings on a money market fund are based upon interest rates and are referred to as the money market yield. Other than the rare circumstances in which a fund breaks the buck, investors in a money market fund generally invest a set amount of money and receive dividends based upon the amount invested and the funds daily yield. Unlike a CD, a money market is generally not required to be held for a specific period of time.
Risks of a Money Market:
- Possibility of fund “breaking the buck”
- Limited earnings potential. A Money Market fund pays a dividend tied to current interest rates, which may be lower than you could potentially earn in other investments.
- Trading flexibility to access money at any time for potentially earning a higher interest rate in a CD.
Cautionary Tails
Early in my career I worked in the phone bank for a major mutual fund company. This was during the tech boom of the late 1990s. Regularly I would speak to investors who were placing all of their money, which they could not afford to lose, in the most aggressive funds. When I attempted to counsel them on the risk, they did not listen. It became clear to me that these individuals had lost sight of their accounts as a resource for sustaining their lifestyle. Instead, they were treating their money as if they were in a competition with the market or other investors. They were more concerned about missing out on a few percentage points of gains than they were with the potential for catastrophic loss. Sadly, when the tech bubble burst, many had lost money that they really couldn’t afford to lose.
Conversely, I have seen many individuals so worried about a market decline that they withdraw all of their money from the market and place it in cash whenever there is a market correction. Frequently they sell their stocks at a low price, miss out on much of the market recovery, and then buy back in at a higher price. Selling low and buying high is a surefire way to lose money when investing. People may think they are being conservative by selling, but a sale during a down turn really indicates they were invested too aggressively for their personal tolerance.
Focus on That Within Your Control
It is so easy to get caught up in the drama of the stock market. What is it doing today? Have we reached the high/low? What are other people doing? Ultimately, however, each of us should be concentrating on our own time horizon and our personal tolerance for risk.
As we have heard from numerous personal development influencers, we must focus on what we can control. It is when people try to outwit the market that they are most likely to suffer substantial losses. Choosing suitable investments is within our control. Staying the course and holding investments for the long term, despite market fluctuation, is within our control.
Often people discuss investments as if they are one-size-fits-all products. But there is no best investment. There is just a best for you investment. I encourage everyone to consider their goals, willingness and ability to take risk, and time-frame prior to making any investment.