Would you consider losing 10 kilos in a month? And running 10 kilometers if you have never put on a pair of sneakers? Of course not. What’s more, you shouldn’t either: both would pose a significant risk to your health.
It’s a similar story with your finances. The goal you set for yourself is as important as the time frame in which you want to achieve it. If you try to move too fast, you will have to take on more risk. That’s why, when investing, doing it in the long term has many advantages and makes sense for ordinary savers.
In fact, one of the things you should decide before investing is the time horizon over which you are going to do this.
What is an investment time horizon?
The time horizon is how long you are going to keep your money invested. This means, the length of time you can do without that part of your savings in order to generate profitability through your investments.
Knowing this time horizon is important to be able to adjust your investment objectives to the risk you take on. To make this clearer, if you want to double your money in 1 year, you will have to invest and assume different risks than if you want to achieve this in 10 years.
In the first case you will need an annual return of 100% and in the second of 7.2%. Do you see the difference?
This is precisely why each investment product has its own recommended time horizon in order to offer results in accordance with the risk you bear. To make it easier for you to choose and to determine the time frame for your investments, there are usually three different time horizons.
- Short term for investments in which you want to get the money back in less than a year.
- Medium term for investments with a horizon of between one and seven years. That is the time you estimate you will not need this money for.
- Long term for investments of more than eight years, although ideally more than ten.
These are general limits, although you can (and should) adjust them to your needs. For instance, for you the short term could be two years if you know for sure that you will need the money in that time. For example, if you have saved capital that you are going to use to buy a house in two years time.
How does this horizon affect your investments?
The length of time you plan to hold the investment plays a decisive role in determining the risk you can or should take on.
Just as you would not start a game of Monopoly if you knew you had to leave in 20 minutes, you should not invest your money in highly volatile products, where the price moves a lot and quickly, if you know that you will need it in three months to change your car, for example.
The reason is simple, in short-term investments you do not have the luxury of time to recover in the event of a fall in the market. As a consequence, the focus of short-term money should be stability and protection. That means being able to recover what you have invested, even at the cost of lower returns.
Anything that strays from this vision is equally valid, but is more a matter of speculation than investment, and you must be aware of the risks involved: you may not get all your money back when you need it.
What happens when you invest over more time? The approach changes and you can add in more risk or potential return, depending on how you want to look at it. As an example, if you invest 20 years ahead, you have a lot of time in which to correct mistakes, so you can invest in more volatile assets.
In other words, you can focus on profitability and not on preserving your capital. Later, as that time horizon shrinks, you can adjust your risk to your new reality. One way to do this is with the rule of 120.
The longer the time horizon, the better the risk-return ratio
No-one knows what will happen in the markets tomorrow and anyone who says otherwise is probably wrong. What we do know, because there is statistical data, is that the stock market generally has an upward trend and that the longer the time horizon of the investment, the less chance there is of losing money.
The following diagram from JP Morgan illustrates this perfectly.