The Advisor's Corner tackles a common situation or issue facing financial advisors and their clients.
When building a portfolio, there are numerous factors to consider—but they generally can be summarized by two main questions. First, what are the objectives for these funds? Second, how long do you have to reach those objectives? The first question is pretty straightforward, but many investors struggle with the second one. This is a concept called "time horizon."
Question: What is time horizon?
Answer: Simply put, time horizon is the length of time money is expected to be invested to meet a set of objectives. Put another way: It's how long the assets need to last. Time horizon has a dramatic impact on how a portfolio should be constructed. For example, let's say your objective is "not to run out of money during your lifetime." If you're 100 years old, chances are you could get by with a portfolio of cash and income-generating securities. If you're 40, the strategy might be completely different. If the objective is to grow the assets as much as possible to pass to heirs, a 40-year-old and 100-year-old might require the same strategy!
Question: How do I determine time horizon?
Answer: The answer depends on the individual investor. For some people, their assets are intended to provide income in retirement, so their time horizon may simply be their life expectancy. Another investor may get all the income he or she needs from Social Security and a pension, so their objective may be to grow their portfolio as much as possible for heirs. In this case, the time horizon may be that of the children's life expectancy since the primary account holder has little to no use for the assets during their lifetime.
In some cases, time horizon may be a specific date in the future (e.g. "I want to buy a house in 2010.") Many people assume their retirement date is the end of their time horizon, as they may plan to take cash flow from the portfolio at this time. This is incorrect. For the vast majority, the beginning of retirement signals a time where their portfolio must work the hardest. True time horizon should be further out.
Question: I'm 67 and retired. Knowing that the average male lives to be about 75, should I only plan my portfolio to survive for 8-10 years?
Answer: This is a fundamental mistake many investors make. With a few exceptions, most people dramatically underestimate their life expectancy. The chart below shows median life expectancy.
(Source: 2005 Internal Revenue Service life expectancy chart)
Someone who has made it to their mid-50's can reasonably expect to live another 30 years, one in their 60's can expect another 20 years, and even a person in their 70s can expect to make it another 10 to 15 years. Plus, remember these are median life expectancies—half of investors may live longer.
In some ways, this is great news. It's hard to complain about living longer. That being said, living longer does present some financial challenges. How do you make your money last for 20, 30, or even 40 years?
Question: How might the portfolio of a person with a long-term time horizon look compared to someone with a shorter time horizon?
Answer: Those with a longer time horizon can afford additional near-term volatility. You might even argue they should accept additional volatility in search of higher returns. An investor with a short time horizon (i.e. less than ten years) may want to avoid having a portfolio that is likelier to go through big up and down periods. But for an investor who needs the funds to last a decade or more, volatility isn't such a big issue. That person has time to "ride out" downside swings in order to benefit from market upside.
Additionally, the longer your time horizon, the more likely it is your primary investment vehicle will approach its historical performance averages. In other words, if you're an equity investor, it's far likelier you'll experience equity-like average returns if you have time on your side. In fact, equities almost always outperform bonds and cash over long periods. For investors with a time horizon of a decade or longer, an all-equity portfolio frequently is most appropriate.