When deciding how to invest your money, the most important question is, “How much risk should I take?” Your answer can mean the difference between meeting your goals—for example, retiring when and how you want—and falling short of them. Unfortunately, many investors don’t know where to start when determining their risk tolerance. What they don’t know is this: how much risk you can take depends on how long until you’ll need your money. Another term for this is time horizon, and while other criteria like emotions are important to consider as well, time horizon is the most important factor for deciding how much risk you should take in your portfolio.
What Is Your Time Horizon?
To determine your time horizon (or horizons, as most investors have more than one), you should consider your various investing goals. Most of us are saving for retirement—that’s a goal, and if you plan to retire at 65, for example, then the time horizon for your retirement savings is the number of years until you turn 65. If you’re saving for a home purchase in five years, your time horizon for those savings is five years. The appropriate risk tolerance for each goal will vary based on each goal’s time horizon.
Time Horizon Impacts Risk Tolerance
There is a simple relationship between risk tolerance and time horizon: the sooner you need the money, the less risk you should take.
Whether you realize it or not, you have probably heard this rule before. Most of us have heard that investors should take less risk with their investments as they get closer to, and eventually enter, retirement. This is because their time horizon has shortened—they will soon rely in part on their savings to support their lifestyle in retirement. If you think about why this rule exists, it makes a lot of sense.
There’s a Reason Why It’s Not “Buy High, Sell Low”
Let’s revisit the example of retirement because that’s a common goal for most investors. As a retiree, there’s a good chance that you will need to sell some of your investments periodically in order to raise cash to support your lifestyle. When your investments are doing well (i.e., going up in value), this isn’t an issue. Selling investments when they’re down, however, does create a problem.
Yes, it’s true that the market typically rebounds after a large decline. And if you don’t sell anything when the market is down, you should be fine. But if you’re retired, or you plan to retire soon, you probably have no choice but to sell investments because you need the money. This creates a problem because every time you sell shares of an investment, you are reducing that investment’s potential for future growth. You’re locking in your losses, and your portfolio won’t be able to rebound as well when the market goes back up.
No matter what your goals are—retirement, buying a house or perhaps saving for your child’s tuition—if you don’t need your savings for a while then you can afford to ride the market’s highs and lows. But if you’re approaching the time when you’ll need that money, it’s important for you to dial back the risk.
Still wondering how much risk is too much or too little for your situation? There are a number of industry guidelines that are out there to help you answer that question, but they are about as useful as your goals are the same as everyone else’s; in other words, they’re not. Instead, we suggest working with an experienced and trusted advisor who can get to know your goals and help you determine the right amount of risk for your goals.