HOW INVESTMENT TIME HORIZON AFFECTS ASSET ALLOCATION

One of the most effective ways to diversify your investments is asset allocation—dividing your investment capital among different asset classes (stocks, bonds, cash, etc.)  Research has shown that the way you apportion your capital among the various asset classes is a better predictor of how your investments will perform than which specific stocks or bonds you happen to buy.  Asset allocation helps you manage the risks and returns of your investments to meet your needs and investment goals.

Along with your ability to handle investment risk emotionally and financially, the biggest factor that should influence your asset allocation decisions is time.  The longer you can hold an investment, the more chance there is that long-term growth in returns will overcome short-term ups and downs in performance.  Being able to hold an investment long-term helps you tolerate more volatile investment instruments and take advantage of the higher returns such investments usually produce.

Likewise, the less time you have to hold a volatile investment, the more likely it is that a short-term drop in value will limit or erase the gains of your investments.  The amount of time you have to hold an investment in order to meet your investment goal is called the investment time horizon.

Stocks, for example, are more volatile, and, therefore, riskier investments than instruments like U.S. Treasury bonds.  Let's say that you purchased shares of XYZ Corp. at the stock market's peak in 1987—just before the infamous "Black Monday" crash.  Let's also say that XYZ stock mirrored the performance of the Dow Jones Industrial Average.  If your time horizon was only one year, and you were lucky enough to sell your stock at the 1988 high, your stock investment would have lost 20 percent of its value.  But if you held your stock for five years, even if you sold at its lowest 1992 price, your investment would have gained more than 26 percent; and if you held it for 10 years, you would have gained almost 132 percent before taxes, even if you sold at the 1997 low.  The rising trend of the stock market over time more than made up for one of the largest crashes in history.  Meanwhile, a "safe" 30-year Treasury bond purchased the same year would have gained 106 percent before taxes. 

Let's look at an even more long-range horizon.  Let's say that in 1926 you had purchased a portfolio that invested 80 percent of your capital in stocks and 20 percent in bonds, and let's say you are going to live past the very ripe old age of 100 (your great-great grandfather was Methuselah).  Over the next 72 years, there would be nineteen years in which your portfolio lost money—including a 35.7 percent loss in 1931 and a 29.8 percent drop during the bear market of 1973–1974.  Yet, even with those disasters, your portfolio would have averaged a very respectable 10.2 percent annual increase in value.

The moral of the story: long investment time horizons allow you to take advantage of the higher returns possible with more volatile investments.  As your time horizon becomes shorter, however, the risk of losing capital on a volatile investment becomes greater; investing in lower-risk instruments like bonds can lower your exposure and protect your capital.

Now let's look at an asset allocation strategy for a common investment goal: sending your kids to college.