Investment Risks – Short-Term vs. Long-Term
Misaligning your investment allocation with your time horizon is a common mistake if you are not familiar with different types of risk. What do we mean by this? If you are going to invest for the future retirement, college expenses, or a home down payment that time in the future when you need to sell your investments for cash to spend is your time horizon. This is important because your time horizon should be a large driver of your asset allocation, or how you invest your money between stocks, bonds, and other asset classes. This article will highlight the different risks over short and long-term periods.
Short-Term Time Horizon
For investment goals with a short-term time horizon, such as funds earmarked for a coming home down payment, a key risk is stock market volatility. Having this balance invested in the stock market, defined as the S&P 500, is concerning because it could experience a sizable decrease in value right before you want to buy your home. We saw this in 2008 when the S&P 500 dropped 37 percent. This could send prospective home buyers scrambling for additional funds if they need to use this balance before the market has fully recovered. How long of a time horizon is considered short-term? It is difficult to know what the next market dip will look like, but historically it has taken the stock market about 3.3 years on average to recover from a bear market since 1926 (a bear market is defined by a decrease of at least 20 percent from the pre-decline high).1 If we extend this period to be conservative, we could say that funds needed within five years or less should be invested in low volatility asset classes that have little to no chance of losing value in a market correction, such as cash held in an FDIC insured bank savings account.
Long-Term Time Horizon
As we mentioned in our February 2016 Article, investors with a long-term time horizon do not need to sell their investments for many years and therefore have time to let the market recover from periodic dips. For example, young physicians with at least 20 years until retirement should have minimal concern for market fluctuations and view market declines as good buying opportunities. Instead, there is a different risk to consider inflation, which can subtly erode your purchasing power over time. Inflation is the increase in the general cost of living and can significantly impact your ability to buy goods and services in retirement if your savings have not kept pace with, and ideally well outpaced, inflation along the way. According to the Bureau of Labor Statistics, inflation has averaged between 2.6 percent to 4.1 percent per year looking back over the past 30 to 50 years measured by annual changes in the Consumer Price Index for all urban consumers (CPI-U, a common inflation gauge).2 How much of an impact could this have? If inflation were a constant 3 percent per year for the next 30 years, $1,000 of today's money would buy only $412 worth of goods and services in 30 years, causing a loss of almost 60 percent of your purchasing power. Investments with a long-term time horizon can afford to weather stock market volatility and should be in asset classes that have tended to outpace inflation over long periods, such as equity (stock) mutual funds.
Short and Long-Term Time Horizons
What do you do if you have both short and long-term time horizons? This is the predicament current and soon-to-be retirees face. They need a portion of their savings to provide income in the form of dividends, interest, or withdrawals of capital and cannot afford to have these funds lose significant value. A retiree may hold two to three years of living expenses in cash and several more years of expenses in a conservative bond allocation to guard against a stock market decline. The rest of their portfolio may have more stock exposure to provide income for later years in retirement, when inflation remains a risk.
The next time you are determining how to invest, ask yourself "When do I need this amount back as cash?" and allow this to guide your allocation decisions.
This article was authored by Marshall Weintraub, CFP®, and Michael Merrill, CFP®, CLU®, ChFC®.
1. Hulbert, Mark, "Don't Fear the Bear." The Wall Street Journal. Dow Jones & Company, 7 Mar. 2014. Web. 20 Feb. 2017.
2. U.S. Bureau of Labor Statistics. Databases, Tables & Calculators by Subject. Consumer Price Index - All Urban Consumers, U.S. Bureau of Labor Statistics, 20 Feb. 2017, https://data.bls.gov/timeseries/CUUR0000SA0?output_view=pct_12mths. Web. 20 Feb. 2017.