The length of time you will or can be invested is important because it can directly affect your ability to reduce risk.
Time diversification is most critical for volatile investments such as stocks, where prices fluctuate greatly over the short term, but are considerably smoothed over longer time periods.
If your time horizon is short, you cannot effectively be diversified across different market environments. Longer time horizons allow you to take on greater risks—with a greater return potential—because some of that risk can be reduced through time diversification.
How should time horizon be measured? Your time horizon starts with whenever your investment portfolio is implemented, and ends when you will need to take the money out of your investment portfolio.
If you are investing to save for a specific event, such as tuition payments or the purchase of a house, your time horizon is fairly easily measured—it ends when you need the cash.
If you are investing to accumulate a sum for periodic withdrawals, such as during retirement, your time horizon is more difficult to quantify as you approach the time that withdrawals will begin. For instance, when you retire, you may need to take out only part of your investment portfolio as income each year. Your time horizon will be a blend—partly short-term, and partly intermediate- or longer-term.
What constitutes short-, intermediate- and long-term horizons?
Time diversification is directly affected by time horizon, so it makes sense to use that as a starting point. Since time diversification is most effective for the most risky investments—stocks—it sets the long-term horizon.
To diversify over various economic cycles, you must be invested through one complete economic cycle at the very least. In general, the economic cycle lasts about five years, which can be considered a long-term horizon. An even longer-term horizon—over 10 years—would cover several cycles and ensure even greater time diversification, which is useful when investing in particularly risky stocks.
What about short- and intermediate-term horizons? Since the horizon is less than five years, stocks shouldn't be considered. In addition, the sooner you need the investment, the greater the need for principal protection and ease of selling.
A short-term horizon—under five years—effectively limits you to fixed-income securities. If you need the money within a year or two, you are limited to the shorter end of the fixed-income spectrum—money market funds, very short-term bonds and short-term certificates of deposit. A somewhat longer-term outlook—two to five years—allows you a little more room to earn higher returns using intermediate-term (less than five years) bonds and intermediate-term certificates of deposit.
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