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Investment Time Horizon Explained

December 3rd, 2008 ·

As I’ll be traveling for most of December, I’ll be running guest posts from other bloggers and readers. To kick thing off, today’s guest post is courtesy of ABCs of Investing — a brand new site for novice investors offering two short and simple investing posts per week. You can subscribe to the feed here.

One common complaint this year regarding the market crash is that people who were planning to retire in the next few years might have to delay their retirement. I’ve heard of a similar problem recently with the failed BCE takeover, where some people are upset because they had plans for the money once their shares were bought out. Yet another situation was someone thinking of buying a house and using the Home Buyers Plan to borrow money from their RRSP - however the RRSP account had lost so much value, they can’t borrow from it anymore.

One of the key concepts in financial planning is that of investment time horizons. Your investment time horizon is the amount of time from now until you need to sell your investment. In order to manage risk, you need to try to match your time horizon with the risk level of your portfolio.

Volatility and risk

The expected return from equities is higher than that of other investments such as cash and bonds. This difference, which is called the “equity premium”, reflects the higher amount of risk assumed when owning stocks. Sometimes investors make the mistake of forgetting that expected returns for equities are only reasonable over the long term (i.e. 20 years or more). Any individual year or even group of years can have a very wide range of returns — both positive and negative. 2008 is a great example of an extreme negative result.

Long term bonds can also be fairly volatile if there is a long time to maturity. If interest rates rise, then bonds will fall and vice-versa.

On the other end of the spectrum we have good old cash. The great thing about cash is that although the expected return is very low - roughly 3% at the moment (which doesn’t include inflation), at least you don’t have to worry about any volatility. If you put $5,000 into a high interest TFSA on Jan 1 then that $5,000 will still be there in June plus a bit of interest.

Match the investment to the horizon

The lesson to be learnt here is that you have to choose the right type of asset class for your time horizon. If you have a long investment horizon then you can afford the risk of owning equities. If you have a very short time horizon then you should probably stay in cash. Anything in between should have some combination of risky/guaranteed investments.

The idea behind choosing the proper investment to your time horizon is not to increase your investment return, but rather to increase the probability that the required amount of money will be there when you need it.

Some scenarios

Here are some sample investment time horizon scenarios - please keep in mind that there are no “agreed upon” lengths of time for various term lengths.

Short term - Susan is 25 and saving part of her RRSP to use as a down payment for a condo in the next couple of years. In this case, the portion of the RRSP to be used for the downpayment has a very short time horizon and should not have any stocks or long term bonds. This amount should be in cash or some sort of money market funds.

Medium term - Bob and Gertrude are 33 and want to buy a cottage in about 10 years. In this case they should have some equities but not too much. Perhaps a 50% equity/ 50% cash/short term bond would be appropriate. As they get closer to the potential purchase date, they will want to increase the non-equity portion. Once they get to within 4 or 5 years of the purchase they might want to be 100% cash or short term bonds.

Long term - Johnny is 38 years old, has $100,000 in his RRSP and is not planning to retire for at least 20 years and will probably live another 25 years after that. Johnny can afford to have most of his investment in equities because of his long time horizon. But, he does have to consider other factors such as how well he can handle volatility.

Don’t lump everything together

If you will be drawing from your investments at different time intervals then it is important to separate your portfolio by time frames. If you are retiring in 3 years then consider putting away about 5 years worth of withdrawals into cash. As you use up that cash in retirement you can sell equities to keep up the cash cushion. Since you have 5 years worth of cash, you also have the option of not selling any equities for 5 years - a retiree might choose to wait it out after a year like this one, rather than sell any equities. Younger retirees have several different investment time horizons ranging from short to long, so they need to have a portfolio that reflects that. They shouldn’t have all bonds or all equities.

Similarly, a house hunter who wants to borrow $20,000 from their RRSP should put that money into cash or money market funds. The remainder of their RRSP, however, should be considered a long-term investment and allocated appropriately.

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26 responses so far ↓

  • 1 charles // Dec 4, 2008 at 3:46 am

    I wished i have alot of money to invest in the stock market.

  • 2 Dividend Growth Investor // Dec 4, 2008 at 10:29 am

    Wow that’s a great article. Abc are you looking for more guest publishers for your articles?

  • 3 ABCs of Investing // Dec 4, 2008 at 10:47 am

    Charles - don’t we all!

    DGI - Thanks for the nice compliment! At the moment I’m not looking for more blogs to publish on - I have a number of guest posts coming out this month already. I’ve been mostly focussing on larger non-investment blogs since I figure that crowd is a better target to learn the basics of investing.

  • 4 EconStudent // Dec 4, 2008 at 3:42 pm

    ABCs: You should mention in the post that long term means something like 75% equities/ 25% bonds. That would be helpful for the reader.

    For the midterm, I have been thinking about alternatives to the traditional 50%/50% or 60%/40% asset allocation schemes. How about some financial engineering? 95% bonds and 5% options. The major advantage of options is that one can go either bullish or bearish. With 95% in bonds (Treasuries to be safe), you know the majority of your portfolio is safe. It is an interesting albeit harder way to a design portfolio.

  • 5 ABCs of Investing // Dec 4, 2008 at 5:17 pm

    EconStudent - I didn’t want to get into specific allocations mainly because there is not much consensus on
    a) how long is the long term? and
    b) how much equity should you have. Personal risk tolerance is a big factor here.

    Some people want 100% equities when investing for the long term - other people want 25% equities.

    I’m not sure about your options plan - options don’t last long so you could easily be down 5% if most or all of the options expire worthless.

  • 6 NN // Dec 4, 2008 at 6:32 pm

    Options should really not be considered by the average DIY investor. Only those comfortable with deriving the Black-Scholes formula on their own, and familiar with the shortcomings of the theory behind it, should dabble with options.

  • 7 EconStudent // Dec 4, 2008 at 8:05 pm

    NN: I see. I find options quite hard to use, but I read somewhere about using options and bond allocation for a portfolio.

    Do you know any good starter material for options? I have difficulty understand Black-Scholes formula.

  • 8 NN // Dec 5, 2008 at 1:23 am

    EconStudent - I believe Nassim Taleb proposed something similar to your suggestion in his book The Black Swan. However, the man has a PhD in mathematics, and was an option trader for years.

    I have very little understanding of derivatives, although it seems interesting enough to perhaps make a study of it sometime. Until then, I am content investing in assets that I do understand (to some extent). I know of quite a few people who ‘invested’ in options without realizing they could have a 100% loss until after the fact.

  • 9 Brian // Dec 5, 2008 at 11:17 am

    CC,

    In a dividend growth portfolio, does it still make sense to gradually move to cash/bonds as retirement gets closer?

    I would assume that a dividend investor would keep their equity positions and live of the distributions without needing to sell the stock for bonds.

  • 10 Dividend Growth Investor // Dec 5, 2008 at 1:16 pm

    Brian,

    Even for a dividend investor portfolio ( which is essentially a stock portfolio) one should consider at least a conservative 25% allocation to fixed income for diversification purposes.
    What you could do is either make most of your new contributions close to retirement to fixed income in order to move the fixed income percentage closer to your target. Another strategy could be to invest your dividends for 5-7 years in bonds before retirement. If your portfolio yields 4-5% you should be able to create a 25% allocation to fixed income just from the dividends.

    A third way could be to sell portions of your dividend stocks due to a variety of reasons and buy fixed income with the proceeds.

  • 11 ABCs of Investing // Dec 5, 2008 at 4:39 pm

    I agree with DGI - having a 100% equity portfolio is ok if it can generate more than what you need to survive but the fact is that dividends aren’t guaranteed. Who’s to say there won’t be some event (which might be happening now) that will result in your total dividend income being cut by 50%?

    I would think about having either a percentage of the portfolio in cash or maybe have several years expenses in cash. That way you weather a bad storm.

  • 12 The Well-Heeled | Creating Wealth Through Knowledge // Dec 5, 2008 at 4:42 pm

    [...] The Canadian Capitalist: Investment Time Horizon Explained [...]

  • 13 NN // Dec 5, 2008 at 9:39 pm

    Brian - I would expect that someone who focus on dividends for income would have a higher equity allocation than normal. The volatility in the capital value is irrelevant if you don’t plan to ever sell your holding. Offcourse, as ABC point out, dividend payouts can and will fluctuate, and for that you need some fixed income holdings to ensure a minimum level of income. I believe the ability of companies to grow dividends in excess of inflation more than compensate the investor for capital volatility.

  • 14 ABCs of Investing // Dec 5, 2008 at 11:40 pm

    NN - I don’t agree. Yes, some companies will do well with their dividends - some will do ok and some will do horrible. It’s no different than picking stocks for capital gain.

    Can you pick the long term winners?

  • 15 NN // Dec 6, 2008 at 1:29 am

    ABC - No, but the dividend growth of the index exceeds CPI, at least for the US market. I would not attempt to pick individual stocks. However, there are some low cost value ETF’s that usually have higher yields than the broad index. An investor must make a decision between having a stable income and having a growing income, considering his/her individual circumstances. I believe that the objective should be to grow (or at least maintain) your income in real terms, and volatility is the price you pay for that.

  • 16 Lisa // Dec 6, 2008 at 5:38 am

    For sure, there is some risk, keeping this fact in mind it is more useful that we keep 5 years worth cash. Taking risk is not bad at all, but for the sake of survival there should be some cash so that we would not need selling of some stocks.

    Lisa

    London Hedge Fund Jobs

  • 17 EconStudent // Dec 6, 2008 at 10:54 am

    NN: Thanks: I will read the Black Swan than. I have not been comfortable with the idea of “Black Swan”, because market crashes like this occurred in 1929 and 1974. As a result, crash of 2008 isn’t a new kind of historical event. Due to your encouragement, I finally understood options last night by rereading the appendix of Random Walk down Wall Street. I must of read that Random Walk down Wall like 4 times so far this year. Every time I reread it, I get more out of it. It is unbelievable.

    I am wondering if you have any suggestions about getting my CFA level I.

    I need a mentor to guide me to be successful in finance even when I am still in university. Like many here, I disagree with the mutual fund sales model, which doesn’t benefit investors.

    I have given up on writing a business proposal for Vanguard to come to Canada. However, I am considering joining Philip, Hager, and North as a start for my career. PHN is the T. Rowe Price equivalent in Canada and does offer some of the lowest cost actively managed retail funds in Canada. I hope PHN can continue lowering the MER of their funds. Of course, there is no Vanguard equivalent in Canada unfortunately and I don’ think there will be one due barrier in entry and initial lack of economics of scale.

    This has been a very long post. Any response would be appreciated.

  • 18 ABCs of Investing // Dec 6, 2008 at 2:20 pm

    NN - there is nothing guaranteed about the past dividend growth rate going forward. Stocks are supposed to return X% per year but over long periods (ie 20 years) the actual results can be quite different.

    EconStudent - Random Walk is a great book in my opinion. The CFA is a very good course. I wouldn’t limit yourself to specific companies to work for - PHN was bought by RBC so they aren’t independent anymore. Maybe Steadyhand would be a better option for you?

  • 19 EconStudent // Dec 6, 2008 at 3:53 pm

    ABCs: I think PHN is still a great company after being bought by RBC.

    Is Steadyhand structured like Vanguard? I read that Steadyhand started very recently, but I think its MERs is quite high except Saving Fund. It needs economies of scale before MER can go lower. I will keep Steadyhand in mind when I do my job applications in Fall 2009.

  • 20 NN // Dec 6, 2008 at 5:12 pm

    ABC - indeed, nothing is guaranteed. But if we choose to ignore past data because the future is uncertain, what do we use for asset allocation decisions? The conventional wisdom that equities outperform bonds which outperform cash is out of the door then, and we start each day from scratch.

    A retirement strategy that tries to maintain nominal income with high allocations to fixed interest instruments coupled with capital depletion is a high risk strategy in my opinion - the retiree is bound to have a decreasing real income and capital base.

  • 21 ABCs of Investing // Dec 7, 2008 at 12:55 am

    NN - some great points.

    I’m not saying a good alternative to dividend investing is fixed income investing - just that no method of investing is perfect so it’s not a bad idea to have a plan B in place (ie have some cash).

  • 22 NN // Dec 7, 2008 at 1:58 am

    ABC - agreed, a balanced portfolio is a necessity. In my (limited) experience, people about to retire focus mainly on nominal income and capital protection, without sparing a thought for the cripling effect of inflation. Most of us should hope for a long life, i.e. investing in retirement should also have a ‘long term’ component :)

  • 23 EconStudent // Dec 7, 2008 at 10:13 am

    NN, ABC - What do you guys think about REITs as a fixed income investment?

  • 24 ABCs of Investing // Dec 7, 2008 at 10:34 am

    NN - yes, a long life (with good quality) would be nice! :)

    Econ - REITs are not fixed income. I consider them on the same level as equities as far as risk is concerned.

  • 25 Canadian Capitalist // Dec 9, 2008 at 2:29 am

    Too bad I had to miss the nice discussion between NN and ABC. To be honest, I haven’t given too much thought to portfolio construction and withdrawal strategies during retirement. I agree that a large bond component makes sense in retirement. I would count on consuming dividends from stocks with a reasonable degree of certainty that it will keep pace with inflation (that’s the long-term record, the double-digit increases of the recent past were not sustainable anyway).

    EconStudent: I think of options as speculative vehicles. They don’t have an expected rate of return — in fact, after expenses options are a negative sum game. It is hard enough making money in positive sum games like stocks and bonds.

  • 26 NN // Dec 9, 2008 at 10:51 am

    EconStudent - The volatility associated with REIT’s would put them closer to stocks than bonds, however I like their potential for increasing payouts in line with inflation. I can see myself having a decent exposure to them in retirement. The higher MER’s of REIT ETF’s are a pity though…

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