Time Horizon and Risk Tolerance

Should you buy stocks, bonds, mutual funds, or exchange traded funds (ETF)? Should you buy Cisco or GE? Vanguard funds or Pimco? 

The themes of time and risk are repeated in books, blogs and YouTube videos everywhere. How often have your heard that you should diversify your investments? Diversification is a form of risk mitigation. If you knew with absolute certainty that a given investment would take off and yield high profits, then why would you buy a mutual fund with a hundred different investments spread across stocks and bonds?

When I started investing in my 20’s, I made the mistake of ignoring time and risk and just dove into researching individual stocks. I engaged in typical swing for the fences investing. Ignoring advice I’d heard or read up until that point, I felt like I just needed to jump in and start researching individual investments. This was also the late 90’s by the way, and the stock market was in the midst of a major bubble. Everyone and anyone had a hot stock tip, usually it was some tech company that you never heard of and no one could articulate what the company did or how they made money. This was the worst possible time for a young, undisciplined version of myself to dive into the stock market head first.

Fast forward 20 years and I’ve come along way, but I am really surprised at colleagues and friends I run into that look at me sideways when they recommend an investment and I ask them, how does this fit with your financial plan?  Or more specifically, how does it fit with your time horizon or risk tolerance?  Have you assessed your downside risk?

Investing without a plan or consideration of time and risk is like taking random types and doses of medicine to cure some ailment.  You need to first assess the condition so you can take the right medicine at the right dosage.

In my experience answering the typical questions around time and risk have not only helped me get good returns on my investments with lesser effort, but also given me less stress. 

If I could go back to my 20’s and do things over again I would start with assessing time and risk first, and do so in parallel with goal setting and development of personal finance principles. My thinking here is that by assessing investments first will lead to confirmation bias and in turn investment decisions that go counter to my principles.

My Time and Risk Considerations

In reading a lot of other people’s work on this topic, I’ve condensed a lot of my lessons down to these simple considerations:

1. Time horizon – time can be broken down by:
   1. What is the amount of time you will be investing or building wealth?
   2. When or what time will you begin to withdraw from your investments?
   3. How long do you expect to be drawing on your investments. Asked another way…how long do you expect to live?
2. Risk tolerance
   1. What is your general mindset to ups and downs in the market, can you ride out a bad market?
   2. In the past, have you tended to sell your investment when it went down in value?
   3. When it comes to investing I am a: beginner, intermediate, or expert?

The Time and Risk Questions

Any decent financial advisor will seek to understand you properly, and they will do so by asking specific questions similar to the ones I list below. That way, this advisor actually knows how to allocate your investments, and better yet, adjust them overtime.  I’ve spoken with perspective advisors that have launched right into investment allocation, without even knowing my age!  Just hang up the phone or walk away….

Below are questions that I use to assess my time horizon and risk tolerance.  For the risk questions I try to put myself in a hypothetical position, really imagine what would go through my mind under different scenarios.  These are good to revisit every year at least, just to make sure you’re still on the right path. 

Time Horizon

• Time Horizon question 1: What is the amount of time you will be investing or building wealth?

Time horizon is easy if you’re immersed in your quest for financial independence.  If so, then you probably have some time or timeframe for when you want to attain this goal. If you haven’t started on that quest yet, then great, hopefully reading this post will help you get started.  

The first step is to pick a realistic and attainable date for retirement. The difference in years of your retirement age to your current age is going to dictate how you invest and were you invest.

• Time Horizon question 2: When or what time will you begin to withdraw from your wealth?

Hand in hand with step one, is to decide how you will retire.  Will you still be earning and investing? Do you expect to live off of your already hard earned investments, and therefore withdrawing, or how about a combination of both?  There are many ways about it, and you may not get it exactly right at first. But at least try to get it close.

Perhaps you have a side hustle you’ll hang onto in retirement. Or perhaps you’d plan to occupy your time with other interests that don’t earn income.  The answer here will help you formulate your investment plan.

• Time Horizon question 3: How long do you expect to be drawing on your wealth. Asked another way…how long do you expect to live?

Are you looking at a mini retirement? Or a lifelong retirement?  If you’re retiring at 30, do you expect to live another 70 years?  The answer to this question will help you further shape your retirement plan. Fair warning, it may result in revisiting time horizon questions 1 and 2, or it may result in other avenues like a hard look at your living expenses, whether or not you need a side hustle, and so on.

Risk Tolerance

• Risk Tolerance question 1: What is your general mindset to ups and downs in the market, and will you ride out a bad market?

Imagine you have $20,000. That’s your entire life savings. Without it, you’d have just enough money in your checking account to last about six months.  If you took that $20,000 and invested it, and it went down 30%, what would you do? Would you sell so you could recoup what’s left? Or would you ride out the market. This question goes hand in hand with your time horizon of course, but if you had say a 5 year horizon and year 2 this happened, what would you do?  Think hard on this question because quite frankly, the probably of it happening is high. 

• In the past, have you tended to sell your investment when it went down in value?

Have you already had a go at investing, whether it’s stocks, ETFs or mutual funds? If so, what happens in say 2008, when stocks dropped over 30%, would you sell? Buy more?  This is more important for people with longer time horizons that really just need to ride things out. Ideally if you were on a short timeframe, your asset allocation would be such to reduce downside exposure to a steep drop on the market.

• When it comes to investing I am a: beginner, intermediate, expert?

Time to be honest, have you been playing hedge fund manager? Read a few books or blogs, read the Motley Fool, spend time on the yahoo finance stock screener?  How well have you done?  Make sure to include all the fees, taxes, subscription services….and time spent.  How does it look now? Still good?

Would you buy an investment solely off a tip from someone you know? 

It’s ok here to admit you’re a beginner or intermediate, you can’t fake it until you make it here. If you’re honest with yourself, you may want to seek out a professional advisor, perhaps over time you can learn and emulate what they do.  Even the “rich” who are investment savvy use financial advisors, if for no other reason than to take out their emotional tie to their money (not to mention save them some time…).

This is where you want to be honest and figure out if you should go it alone or with help from a professional. Just remember some good advice from Warren Buffett on investing: 

Rule number 1 never lose money. Rule No. 2: never forget rule No. 1.

Warren Buffett

Putting the two together

There are numerous online resources to help you dial in your asset allocation ratio, I personally recommend the free Vanguard questionnaire here.

The combination of your age and how long you expect to live will feed into how much risk you can reasonably handle.  A 20 year old with 40 years of working ahead of them can afford more risk in their portfolio simply because they have time on their side. But for a 50 year old retiring at 55, time is not as much on your side and that should be accounted for in your risk tolerance. But then again there are people that are willing to take on much more or much less risk given their own preferences.

One of the things professional money managers and professional gamblers have in common is they know how to enter in and out of investments with a consideration of time and risk. Professional money managers do not to go in head first on a hot stock tip from a hotdog vendor, and professional gamblers do not randomly wander through casinos and plunk down money on a roulette wheel. They both pick and play their games deliberately so as to ensure the best possible outcome.

Bottom line, investing without consideration of your time horizon or risk tolerance is impulsive and thoughtless and should therefore be avoided at all costs.