Time horizon definition
A time horizon is a way to assess your risk tolerance or risk capacity as an investor. At its core, a time horizon provides the answer to a critical question: When do you need this money?
Time horizon example
One investing goal that everyone share is a comfortable retirement. The normal retirement age is 67, but let’s say you want to retire a bit earlier at the age of 65. If you’re 30 years old in 2021, your time horizon encompasses the 35 years between now and 2056. Earlier in your career, you’ll need to accept bigger risks with your investment to accelerate your growth and feel comfortable enough to leave the workforce in 2056.
When thinking about retirement, though, it’s important to recognize that you’ll need to think about another time horizon. You don’t need all the money on the day you retire. Depending on your health and your history of family longevity, your money may need to last approximately 30 additional years.
List of common time horizons
Since you have multiple objectives for your money, you will think about a range of different investment time horizons at once. From working toward a new car purchase to planning to buy a vacation home, you will need to evaluate each of your goals with the calendar in mind. Here are three common time horizons.
Short-term time horizon
A short-term time horizon refers to money you will need to access soon. An example of a super short-term horizon is your emergency fund, which you can park in a high-yield savings account or money market account. If an unexpected, worst-case scenario arises tomorrow, you will need your money immediately to cover some expenses. Other financial needs fit into the short-term horizon category, albeit with a slightly more distant horizon. If you’re saving for a down payment on a house, you might be aiming to reach your goal before the lease on your rental apartment is up in 11 months. You can’t afford to lose value, but some extra growth would certainly help. Perhaps you’ll put the money in a short-term certificate of deposit to take advantage of a bump in interest earnings.
Medium-term time horizon
What fits into a medium-term time horizon may vary based on how you look at your objectives, but these tend to be somewhere between five and 10 years away. For example, if you are saving for college for your 10-year-old, you will need to begin pulling money out for tuition bills in the next eight years. With a longer lead time, you can accept some room for risk, but you will likely have a mix of investments that don’t leave you too exposed to major losses. For example, you might diversify your investments between stocks and lower-risk bonds.
Long-term time horizon
When you think about major goals further away from the present, you are operating on a long-term time horizon. As a younger investor, retirement is the most obvious example of a long-term horizon. If you’re in your 20s or 30s, you have decades of work ahead. The longer you have, the more you can afford to deal with the risks of loss in your investment portfolio.
Why understanding your time horizon is so important
Knowing your time horizon is essential for outlining an investing strategy that meets your goals. The time horizon will dictate a very important distinction: the return of your investment versus the return on your investment. With a shorter time horizon, your focus is tilted toward the return of it; you want to make sure you can get your initial investment back. For example, if you know you need the money next year, you don’t have a lot of time to grow it — and you don’t have a lot of room to risk losing it.
If your time horizon is longer, though, you’ll be thinking about the common definition of ROI: a return on your money. The luxury of extra time will let you stomach more volatility to chase higher returns.
How to determine your investing time horizon
Understanding your investing time horizon begins with determining when you’ll need this money.
Remember that as your time horizon changes, so will your investment allocations. When the date you need your money is closer on the calendar, you will need to adopt a more conservative approach. For example, at 25, your retirement has a long-term horizon. At 60, the money you’ll need to withdraw in the first few years of retirement will have a short-term horizon. You’ll become less focused on growth and more concerned about avoiding any losses.