Time frame is one of the important factors when looking at investment risk. The other two factors are volatility and diversification. Volatility, which could also be thought of as unpredictability, increases risk since the chance that you will get an expected return (or any return at all) at any specific time decreases as volatility increases. Diversification decreases risk since as you add more types of investments their movements tend to offset each other; therefore, it is unlikely that you will take a significant loss since it is unlikely that all of your investments will go down at the same time.
Time has the effect of reducing risk. While the day-to-day price of an investment may be difficult to predict, there are many investments that have a natural tendency to increase in price over time. You know the general direction, just not when the increases would come.
This is kind of like trying to predict the weather. While it might be difficult to predict if it will rain on any given day, especially a few months in advance, one can do fairly well predicting the average yearly rainfall over a period of several years by simply looking at the past history and assuming the averages will remain about the same. While it would be difficult to predict if the price of a stock would increase a week from Tuesday, it can be predicted with fairly good certainty that the return on the S&P 500 will be between 10 and 15% over then next 20 years.
Risk and reward are normally correlated – the greater the risk you take, the greater the possible reward. If you buy a lottery ticket, you are almost certain to lose the dollar you are wagering, but if you do win you could collect millions of dollars. Likewise if you put your money into a savings account, there is almost no risk of losing money, but at the amount of interest you can currently collect it would take about 700 years to double your money.
So, the general rule is that the more time you have before you’ll need the money, the more risk you can tolerate in the form of volatility and lack of diversification. When one has a long time frame (20 years or more), one should be invested primarily in the investment that will yield the greatest return – common stocks. When one needs the money tomorrow, one should be in the investment that will provide the most predictability in value – a money market account. Here are some rough rules-of-thumb:
Time Frame Investments
20+ years Growth Stocks
5-20 years Growth Stocks, Income Stocks, and Bonds
3-5 years Income Stocks, Short-Term Bonds, Bank CDs
1-3 years Bank CDs
0-1 year Short Term CDs, Money Markets
Follow me on Twitter to get news about new articles and find out what I’m investing in. @SmallIvy_SI
Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.