Investment Horizon and what it means to you.
Your investment horizon is the length of time you expect to hold the investment. If you are young and just starting out, then any contributions to your RRSP (for retirement) will have a 40+ year time horizon. But that same young person setting aside money to buy that first home or condo would have a much shorter investment horizon – maybe 3 to 5 years.
The general rule is that the longer your investment horizon, the more risk you should be taking in your investments. This is because risk and return are directly related – the higher risk you take, the more return you get and this has been true for hundreds of years. But it is only true when looking at a long investment horizon – at least 10 years. To understand this, first consider the relative risk of different types of investments.
Investment Risk versus Investment Return
Money Market (GIC) or Government Bonds (loans) are the least risky investments since they are backed by the Bank or by the Government and there has never been a widespread default.
Corporate bonds are more risky since they are issued by individual companies and there have been company failures, making the bonds completely worthless or at least much less valuable than what was invested. Besides failing completely bond prices do move up and down, which also creates risk for the investor
Finally, stocks are most risky since stock prices can move up and down quite dramatically. Movements down tend to be most memorable since they make the news and can happen very quickly (movements up tend to happen more gradually). The last big drops happened in 2001 (burst of the dot.com bubble) and 2008 (financial crisis).
With risk comes return and returns increase as risk increases.
Stocks have consistently delivered superior returns over the long term, followed by bonds and then by money market funds (represented as “Bills” in the figure) as shown below.
Source: Siegel “Stocks for the Long Run” (fifth edition, McGraw-Hill, 2014)
So, if Stocks return almost double the next best investment (Bonds), why not put 100% of your investments in stocks. The reason can be found by looking carefully at the smoothness of the graphs. Note the jaggedness of the stock chart if we look at the last 40 years. If I invested in 1977, I would have had some ups and downs but my overall return would have been excellent (9%).
Now let’s reduce the time horizon to 10 years.
Now we clearly see the downturn in 2008 but the recent strength of the market still made a return in 2007 pay off with a good return (6.4%).
If we reduced the investment period further we would see a strengthening of returns since we’ve been in a strong (bull) market since the 2008 downturn. But what if we had invested just before the 2008 drop with an investment horizon of only 5 years? As you can see, while the market recovered in the 5 year period, the investor would have only what they put into the investment after 5 years (unless they panicked and withdrew their money during the downturn like many novice investors).
If we had an even shorter investment horizon during this period, you can see that your return would have been highly variable whereas putting your money in a GIC would have lead to a consistent positive return (although only a small one).
The point is that higher risk investments produce higher returns but only over the long term. So your choice of investments must be made considering your investment horizon.