EconomyStock Market

How Time Horizon Should Affect Your Investment Portfolio

If you only have a few minutes per day to read up on investing tips, I’m guessing that you tackled the following topics in roughly this order:

  • How does the stock market work
  • How to buy shares
  • How do dividends work
  • Individual shares versus funds
  • How to pick shares
  • What investments should feature in an investment portfolio?

How close was my guess?

I created this list on the assumption that you would prioritise finding out about the mechanics of the market. After all, nobody would feel comfortable spending money in a shop or putting money in a bank unless they understood how shops and banks worked, right?

Once you understand the infrastructure, your focus then moves to the individual assets. What is it I would be buying, and how do I physically buy them? In the stock market, these are both deep topics as shares have so many facets to them (such as what rights and rewards they give to their owners, and how dividends work).

There are also so many different ways to buy shares or at the very little benefit from a rise in the overall stock market. It’s therefore not just an essential topic but a rewarding one to research.

Next comes the question of which shares or funds to actually buy, and should investors prefer one over the other? This opens up the debate about using funds versus managing your own portfolio of individual companies stocks and shares. Busy folk who want a simple portfolio love funds. Control freaks and day traders wouldn’t dream of anything except managing their own portfolio.

Finally, before we invest, we need to understand how a portfolio fits together in the big picture. It’s excellent fun to begin picking stocks and shares, but the portfolio must work together as a cohesive whole to reduce your volatility and ultimately risk.

The investing question that isn’t covered by beginners

In the quick overview above, I’ve intentionally left out a major topic in which all investors should spend time researching and deliberating before they even decide whether investing in the stock market is right for them. Can you see which topic I missed out?

It’s the question of your personal investment time horizon, aka how long you can be sure you don’t need to touch your money for?

Why is Time Horizon an important issue

What’s the big deal? Why can’t we just invest money that we don’t have an immediate need for, and then withdraw it if we happen to need access to the cash?

First of all, some investments in a portfolio are not liquid. This means that in a crisis, you may not be able to withdraw your funds at short notice. Examples include property funds and equity funds that invest in private companies.

Because these funds invest in ‘non-public’ assets (i.e. assets that aren’t themselves listed on the stock exchange for easy trading), then in periods of heavy withdrawals from the fund, the fund manager will need to physically sell their stake in the business, and this could take weeks or months to get a reasonable price. Research what happened with Neil Woodfords failed funds to get a flavour of how liquidity can cause pain for investors.

Secondly, the returns of the stock market can be quite wild in the short term. It is not uncommon for the major stock indices to close a year more than 10% down from their opening value. In such periods, if you happen to need to withdraw your money, then you will crystallize that loss when you are forced to sell.

Long term investors, on the other hand, will be able to wait out any temporary dip in the stock market and sell in a future year when their investments are showing a profit. The ability to wait is therefore a powerful tool that reduces the risk of you incurring a permanent loss on your investments.

If you invest in shares for the short term, i.e. your investment time horizon is very short, then you are investing in a more high-risk investment than a long term investor who buys the same assets. This sounds counter-intuitive, but just think of it: There’s a possibility you might be forced to sell the assets at a loss, but there’s little chance of this scenario for the long term investor, therefore you are in a more vulnerable position despite the fact you’re investing in the same physical asset.

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