An investment time horizon is the time set by an investor until they expect to need their invested capital back. They are primarily dictated by investment goals. And can help identify how much risk an investment portfolio needs to take to complete the specified objectives.

The length of a time horizon can vary greatly between investors. After all, everyone has different financial goals. And so, time horizons can range from a few weeks to several decades.

For example, imagine a young investor just entering the workforce and looking to start investing for retirement early. Their time horizon could span for several decades. By comparison, another investor saving up capital for a downpayment on a house in the near future has less time.

Why is knowing a time horizon important to investors? Because it helps identify what type of financial assets and their portfolio allocations are most appropriate to achieve their goals. Generally speaking, the longer the time horizon, the more risk an investor can take. Why? Because financial markets over long periods typically trend upward.

Factors that affect the time horizon

Three primary factors need to be considered when determining the length of a time horizon.

• Investment Goals – This is often a good starting place as it outlines the ideal scenario by which an investment objective needs to be completed.
• Risk Tolerance – Achieving short-term goals may require an investor to take on additional risk. However, not everyone is comfortable doing so. As such, risk tolerance is an essential factor to consider when determining a realistic time horizon. Suppose an investment objective is only possible by exceeding an investor’s risk tolerance. In that case, the goal will likely be changed or given more time. Most financial advisers always encourage investors never to take on any risk they aren’t comfortable with.
• Age – An easily overlooked factor by younger investors is age. However, an individual nearing retirement does not have as long before their employment income stops coming in. As such, their time horizon to achieve specific financial goals is likely significantly shortened.

Does time horizon affect risk?

Investment time horizons and risks are linked, with one affecting the other. The shorter an investor’s time horizon, the less time they have to recoup any losses that an investment strategy might incur. That’s why short-term goals often need to be paired with lower-risk asset classes.

By comparison, investors not seeking to withdraw their capital for decades can take on far more risk as there is more time available to recover from any potential market crashes or corrections.

Primary types of risks

Each asset class carries its own set of risks that must be considered before making any investment decision.

• Firm-Specific Risk – This encapsulates all the threats and hurdles a company needs to overcome to prevent short-term and long-term bankruptcy. This includes overcoming internal challenges, dealing with rival competition, attracting and retaining customers, raising capital, etc. Firm-specific risk can be mitigated through intelligent portfolio diversification.
• Market Risk – Unlike firm-specific risk, market risk cannot be mitigated by diversification. It represents the possibility that speculative behaviour, stock market crashes, corrections, or geopolitical conflicts will negatively impact the value of an investment. The adverse impact of market risk is always temporary, occurring in cycles. Therefore, it’s only a major concern for traders and short-term investors.
• Default Risk – This applies to both stocks and bonds. It’s the probability of a company or another entity being unable to repay its debt obligations. Most default risk can be avoided by sticking to high investment-grade bonds and verifying that a business has sufficient liquidity and solvency to comfortably cover its financial obligations.
• Inflationary Risk – This refers to the impact of inflation on investor spending power. Even if an investment increases in value, wealth is still being destroyed if the return is less than inflation.
• Interest Rate Risk – This threat is closely tied to inflationary risk. When interest rates are on the rise, the cost of external capital increases causing stock valuations to suffer. For newly issued bonds, debt investors can find more lucrative opportunities. However, existing bonds, especially those offering a fixed rate, can suffer in value substantially as money is moved to newly issued debt instruments with higher payouts.

What are the types of time horizons?

Generally, an investment horizon can be placed into one of three categories.

• Short-Term – A financial goal is expected to be achieved within less than three years. Since capital is going to be needed in the near future, lower-risk securities are often the most suitable, but there are some exceptions. Some examples of popular securities for investors with a short-term time horizon include savings accounts, certificates of deposits, money market funds, and near-maturity bonds.
• Medium-Term – A medium-term time horizon is for investors with a financial goal that has a time frame of three to ten years. Some common examples include saving for a wedding, first home, or university. Typically an investment strategy that balances higher-risk assets like stocks with lower-risk bonds is the most popular choice for medium-term time horizons.
• Long-Term – A long-term investment time horizon is for investors with a financial goal that has a time frame of more than ten years. They’re able to take on considerably more risk than those with shorter timelines, providing they don’t exceed their personal risk tolerance. The most common example of a long-term investment goal is saving for retirement.

The bottom line

Every investor needs to understand and evaluate their desired goals and timeline before deciding on which asset classes are most suitable for their portfolio. Those needing capital in the near term may be wiser to stick to lower-risk instruments like money market funds and high-grade bonds. However, investors with a longer investment horizon can take on more risk to achieve their goals.

This article contains general educational information only. It does not take into account the personal financial situation of the reader. Tax treatment is dependent on individual circumstances that may change in the future, and this article does not constitute any form of tax advice. Before committing to any investment decision, an investor must consider their individual financial circumstances and reach out to an independent financial advisor if necessary.