Match risk to time when investment funds are needed
April 17, 2014
One of the most important points to consider when planning an investment strategy is time. Getting the time issue correct is a strong foundation for investment success.
Matching your investment strategy to the future when funds are needed requires an understanding that investing comes with a certain amount of risk. Managing that risk is important. Risk is defined as the amount of volatility an investment could have over the course of one year.
Stocks are risky because their increase or decrease in value can be significant. Bonds are safer. Although they can change in value, they do not fluctuate nearly as much as stocks.
Who should consider bonds? Which generation should take the risk of investing in stocks? Remember, time is key. To illustrate this we will consider an Oakville family of three generations.
The family consists of retired parents with adult children and their grandchildren who are currently in high school. The retired parents and adult children are investors. Many years earlier, investments were made to help the grandchildren pay for university education.
The retired parents are financially secure. They do not have company pensions but they have a good investment portfolio and plan to live long and active lives.
Their children have also had financial success, so they plan to follow their peer group with one more house upgrades in about a year. The retired parents’ grandchildren are doing well at school. They are motivated to pursue higher education over the next two years.
How should these three generations invest? To answer that we would need more information, but from the brief description given what would you suggest? Of the three generations, which one can least afford to take investment risk? My suggestion is the grandchildren.
They are the youngest generation but their time to go to university is short. If the stock market declined significantly, funds for their university education would not have time to potentially recover in value.
Perhaps the risk of declining funds can be absorbed by their parents. Without that luxury, however, they are by definition conservative investors because of the short time frame.
The retired parents’ children are both short and long-term investors who want to upgrade their house soon. This means those additional funds needed are better invested conservatively because they, like their children going off to university soon, do not have much time before their house upgrade.
Their longer-term needs of planning for retirement means the funds invested for that purpose can have a longer time horizon; therefore, stock investments could be considered.
The retired parents are in a similar situation to that of their adult children. They too would likely have a combination of stocks and bonds. Bonds address the cash flow needs over the next several years.
Stocks are needed to provide growth to keep up with inflation and pay for the expensive later years of life that might include living in a retirement residence.
Our advice is to manage investment risk by considering the length of time before your funds are needed. It is not based on your age but based on the specific time requirements of spending your investment dollars.