Have you ever received a lump sum of money—say a tax return, a work bonus, or a check from a long-lost great aunt (we can dream)—and thought “hey, I should invest this money!”
That’s great. Part of building wealth is all about buying assets that you think will increase in value over time. The real trick is knowing where to begin, and what questions ask. Because sometimes, the best starting place may not be what investors think.
First and foremost, investors should consider their goals and their risk tolerance for that particular pool of money. This step is often overlooked, but it’s hard to make a decision about how to invest without first understanding the ultimate end-goal for that money.
In addition to goals and risk tolerance, there’s another factor that investors should consider, and that’s the investing time horizon. Investors can think of this as their investment time frame.
When an investor has a pool of money that they are looking to invest, they’ll want to ask these questions: What’s my goal for the money? What risk am I willing to take? And, when do I need the money? That last question there, that’s the question of the investment horizon.
Upon asking themselves these questions, investors can puzzle their answers together with the most appropriate investment options available.
What is a Time Horizon?
What is a time horizon? In short, it is the expected time available to achieve a financial goal.
An investing time horizon can be thought of in a few different ways.
First, an investing time horizon can refer to the amount of time that an investor is planning on holding an investment. For example, an investor may be planning to hold an investment for 20 years. Therefore, the investment horizon is 20 years.
Or, investors can think of a time horizon in terms of how long they are working on or towards a goal. For example, one common goal is to save and invest for retirement, which may be decades away.
This investing time horizon will likely be determined by the age of the investor and how much progress they are making towards their retirement goal.
An investment time horizon could also be immediate, long, or somewhere in the middle.
Why is Time Horizon Important?
Understanding your investment goals and timeline is an important step in determining the right investments. That’s because some investments are more appropriate for longer time horizons, while others are better for the short-term.
An investor’s money strategy for a tropical vacation is generally different than for retirement.
Investment types can exhibit different risk characteristics over different time periods. Some investments have more risk over shorter time periods, but that risk may decrease the longer the investment is held. An investment in the stock market is an example of this.
The stock market can be volatile during short time periods, like a month, year, and even five years. But over longer periods, the stock market generally moves much higher.
Historically, the stock market has been a high-performing asset class—but, the chance for higher returns over time takes patience and a willingness to stomach short-term risk, also known as volatility.
Therefore, investments in the stock market may make the most sense for an investor with a long investing time horizon.
In investing, there is a deeply important connection between risk and reward. And often, risk comes in the form of those short-term gyrations in the market. When an investment is volatile, the price of that investment can change, and rapidly. Volatility happens on both the upside and the downside.
But the risk may serve a purpose, in the longer run. Generally, an investment that has more short-term risk may offer the potential for more returns over time.
In fact, long-term investors may want to view risk through a different lens: If they do not take enough risk, they might not reach their investing goals. It is also possible to lose money by doing nothing, due to the effects of inflation. When cash just sits, it tends to lose purchasing power over time.
Asset Allocation and Time Horizon
The purpose of analyzing one’s goals, risk tolerance, and investment time horizon is to land on an asset allocation that is most appropriate.
Asset allocation is the decision to divide portions of a portfolio among the different asset classes. Popular asset classes can include stocks, bonds, and cash.
Asset allocation will have a large impact on the performance of a portfolio over time. It’s not hard to imagine that a portfolio invested entirely in the stock market will perform quite a bit differently than a portfolio being held in cash. And which is more appropriate for an investor will—again—be determined by what it is they are trying to accomplish and by when.
Short-Term Investing Time Horizons
It should be noted that there are no universally accepted time horizons, but here are some guidelines that could help an investor get started.
A short-term investing time horizon could be anywhere between zero and three years.
Here are some examples of short-term money goals: Saving up for a vacation, emergency funds, holiday money, or a down payment on a home.
For the most part, it makes sense to keep money for short-term goals held in cash, because the focus is generally on safety and liquidity.
This can be especially true when the goal does not allow for any timing flexibility.
For example, say that someone is saving up for a down payment on a house. They would like to use this money in six months.
The primary goal for this money is to be able to use it as soon as the right home is identified. Losing any of that money presents a risk that this person could potentially miss out on their ideal home..
Because this is a short-term time frame, and because the objective is to make sure that the money is available for use in six months, it does not make much sense to subject this money to risky assets with high volatility, like stocks and bonds.
Cash can be held in a checking or savings account. This can be done with a traditional commercial bank or an online bank account like SoFi Checking and Savings®.
Another option to consider is a short-term Certificates of Deposit (CDs) at a bank or local credit union. Investors may be able to earn slightly more interest with a CD. Tread carefully, here: There may be a penalty to access money held in a CD before the maturity date.
For short-term goals that are flexible on timing, it may be possible to invest all or some of that money. For example, imagine an investor with the goal of buying a boat in about three years.
Perhaps, this investor has committed to do so only once they’ve made investment gains, whenever those may come. Because they are flexible on timing, and willing to work with whatever the investment markets provide, they could consider investing short-term money.
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Medium-Term Investing Time Horizons
A medium-term investing time horizon could be anywhere between three and 10 years.
Here are some examples of medium-term goals: starting a family or paying for a child’s college education, or potentially a house remodel.
Investing in mid-term goals can actually be more complex than investing for both short and long-term goals.
Likely, an investor will want to consider a balanced approach in a diversified combination of investments. The sooner the goal, the more bonds and cash the investor will likely want to have. The farther out the goal, the more risk that an investor can presumably take.
How much an investor allocates to the stock market will depend on their comfort level with the stock market during a shorter investing time frame, and their willingness to be flexible.
For example, say that someone is creating an investment strategy for a newborn child’s college fund, which will presumably happen over an 18-year time horizon. Historically, 18-year periods are positive in both the stock and bond markets.
But, 18-year periods in the stock market are not as reliable and consistently positive as longer timeframes. Therefore, an investor will have to decide how much risk they are willing to take with their allocation.
Long-Term Investing Time Horizons
A long-term investing time horizon is any amount of time longer than ten years.
Some examples of long-term financial goals include: retirement, financial independence, creating an endowment, and building intergenerational wealth.
How should long-term money be invested? In general, longer investment time horizons allow for more risk—which allows for higher potential for returns. Therefore, it is possible to have the majority of long-term funds invested in the stock market or similarly risky asset classes, if the investor’s personal risk tolerance allows.
The notion of risk becomes somewhat counterintuitive during longer periods. With money that is saved and invested now to be held for use over the long-term, investors may have to contend with losing purchasing power to inflation, in addition to market volatility.
Inflation, which is the economic phenomenon of prices rising, which means that over time, each dollar can buy less. Historically, the inflation rate has run at 3%, which means money that’s “earning nothing” is actually losing 3% each year. Therefore, one of the biggest risks for long-term investors may actually be acting too conservatively, too soon.
For example, consider a 30-year-old investing for retirement. Their target retirement date is age 65, or 35 years from now. This is a long investing time horizon.
(Arguably, the investing time horizon is longer than 35 years, since they will likely need to remain invested, in some capacity, into retirement. It’s helpful to think of retirement as a milestone that may trigger some important changes, but not a drop-dead date for investing.)
Because this investor has an extended amount of time to weather changes in the stock market, they may want a majority of their portfolio invested in the stock market. That is, of course, if they are personally comfortable with short-term volatility. And exactly where they fall on the spectrum will be determined by just that—their comfort level with stock market investing.
For investors saving for retirement, there’s a general rule of thumb for deciding asset allocation. Subtract age from 110 (as age expectancy has increased to 110 from 100), and that’s how much an investor should allocate to the stock market. If an investor is 30, subtract 30 from 110, which is 80.
According to the rule, 80% should be allocated to the stock market, with the other 20% going to bonds. Of course, this is just a general rule – each investor will likely need to use their discretion and evaluate their overall l financial profile and risk tolerance as they make investing decisions.
Choosing a Portfolio Option That Works for You
Upon making a decision about the appropriate asset allocation using goals, risk tolerance, and time horizon, it is time to start building out an investment strategy. There are several approaches to this, and they range by how involved an investor wants to be in the process.
Investors who would like some assistance in building out a portfolio that matches their objectives may want to consider a service like automated investing with SoFi Invest®. After collecting information about the investor, such as their goals and investing time horizon. The automated platform will build out a portfolio that best suits the investor’s needs.
Investors who would prefer to build out their own portfolios may consider doing so using a combination of stocks, mutual funds, and exchange-traded funds (ETFs).
When building out a portfolio, new investors will want to try to keep costs as low as possible. Trading and management fees can eat away at an investment’s potential returns.
Luckily, there are more great, low-cost options for DIY investors than ever before. SoFi Invest® offers free trades, no minimums to get started, and no monthly account fees.
Whether an investor uses an automated portfolio or takes a more active approach, the most important thing is just getting started.
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