Using Time Horizons to Make Smarter Investments

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Whenever you start to choose an investment, one of the first questions you should ask yourself (or get asked by a financial planner) is "what is your time horizon?" The answer is important because the timeframe should guide decisions for the type of investment account and the nature of the investment. (See also: 15 Investing Tips From a #1 Wall Street Stock Picker)

In general, the longer your time horizon, the better you can handle fluctuations in value and take more risk in order to reap greater rewards. Unless you need the money in the next year or so, there is plenty of time for your investments to recover from any market declines, industry shake-ups, or company setbacks, plus years for your investments to grow in market value.

For example, during the 2008 recession, I heard about a couple nearing retirement that had just put its nest egg in the stock market, devastating their retirement portfolio. For a 20-something couple with an investing time horizon for retirement of 40+ years, this scenario would not be a problem.

But the couple who had just recently invested was very close to retirement age and needed to begin taking cash distributions soon. The problem here was not so much poor stock selection or lousy market timing but failure to understand and apply time horizons to investing decision-making.

Time Horizons, Explained

Investopedia describes a time horizon as "the length of time over which an investment is made or held before it is liquidated." So, your investing time horizon starts now until you need to cash in your investments to...

1. Make a specific purchase; or
2. Cover expenses over a period of time.

Types of Time Horizons and Financial Goals

Investing time horizons can be expressed in precise terms (e.g., the exact number of years) or more generally, such as short-term (less than 3 years), mid-term (3-10 years), and long-term (more than 10 years).

When you set financial targets, consider time horizons. For example, you may have timeframes for a number of different goals:

• Buying a home (specifically, saving for a down payment) — 5 years or mid-term
• Sending kids to college— 12+ years or long-term
• Making a major purchase, such as a car or vacation — 1 year or short-term
• Retirement — 35+ years or long-term

Even if you have the same goals as your friends, you may have different time horizons based on your age or other factors, such as the age of your children or plans for retirement.

So, if your children are toddlers, then your time horizon for college savings is long-term, approximately 16-20 years. If your neighbors happen to have teenagers in the house, then their college-savings timeframe is mid-term, probably 5-10 years.

Lump Sum or Stream of Revenue?

Note that some goals require a lump-sum amount to make a specific purchase (such as the purchase of a new car or funding of a European vacation). Others involve generating a stream of income to cover expenses for either a short, pre-determined timeframe (four years of college expenses, for example) or a longer, less definite amount of time (retirement, which could range from 10 to 40 years or more).

The time horizon for the stream of income should extend beyond the start date to the end date; for example, if you are saving money to send your 16-year-old to college, then your time horizon is six years (two years until starting college plus four years of college).

How to Use Time Horizons in Investing

There are two main ways to use time horizons for investing. First, you want to match the account type with the time horizon. Second, you want to choose the type of investment that will give you the best return over the time horizon.

In the Short Term, Reduce Risk

For example, if you are saving for a down payment on a house that you plan to buy in a couple of years, you may choose to save inside of a regular savings account, money market account, short-term bond, or a CD that matures in 24 months or less. If you are unsure about the exact time frame, then you might want to sock away funds in a regular savings account so cash will be available without penalties when you are ready.

In the Long Term, Seek Return

If you are saving for retirement and still have 20 years or more until that time, then a tax-advantaged account, such as a 401(k), traditional IRA, or Roth IRA would be a better choice than a savings account. You could fund the account with a selection of stocks and bonds depending on your time horizon as well as other factors such as risk tolerance. A dip in the value of your investment portfolio in the next few years would not make a difference in your long-term prospects as long as you didn't have to tap the funds to pay medical bills, make a down payment on a house, or support yourself prior to retirement.

As retirement nears and becomes a reality, you can change the investment mix, generally moving from riskier investments like stocks to safer ones such as fixed-income investments. These asset-allocation adjustments allow you to keep some investments in the market yet still enjoy liquidity needed to pay living expenses.

For a visual representation of this concept applied to real-life investing decisions, T. Rowe Price provides a chart with investment mixes based on time horizons associated with various financial goals.

The couple who invested in the stock market at the time of its significant decline may have been fine financially if they could have waited five or more years to tap their retirement funds. But if they needed the money right away, they may have quickly depleted their savings.

Matching your investing time horizon with your investment decisions — a relatively simple task — can make a big difference in your long-term financial health.

Have you used the time horizons concept to plan or determine your investments? Please share your experience in comments.