As I’ll be traveling for most of December, I’ll be running guest posts from other bloggers and readers. To kick thing off, today’s guest post is courtesy of ABCs of Investing — a brand new site for novice investors offering two short and simple investing posts per week. You can subscribe to the feed here.
One common complaint this year regarding the market crash is that people who were planning to retire in the next few years might have to delay their retirement. I’ve heard of a similar problem recently with the failed BCE takeover, where some people are upset because they had plans for the money once their shares were bought out. Yet another situation was someone thinking of buying a house and using the Home Buyers Plan to borrow money from their RRSP – however the RRSP account had lost so much value, they can’t borrow from it anymore.
One of the key concepts in financial planning is that of investment time horizons. Your investment time horizon is the amount of time from now until you need to sell your investment. In order to manage risk, you need to try to match your time horizon with the risk level of your portfolio.
Volatility and risk
The expected return from equities is higher than that of other investments such as cash and bonds. This difference, which is called the “equity premium”, reflects the higher amount of risk assumed when owning stocks. Sometimes investors make the mistake of forgetting that expected returns for equities are only reasonable over the long term (i.e. 20 years or more). Any individual year or even group of years can have a very wide range of returns — both positive and negative. 2008 is a great example of an extreme negative result.
Long term bonds can also be fairly volatile if there is a long time to maturity. If interest rates rise, then bonds will fall and vice-versa.
On the other end of the spectrum we have good old cash. The great thing about cash is that although the expected return is very low – roughly 3% at the moment (which doesn’t include inflation), at least you don’t have to worry about any volatility. If you put $5,000 into a high interest TFSA on Jan 1 then that $5,000 will still be there in June plus a bit of interest.
Match the investment to the horizon
The lesson to be learnt here is that you have to choose the right type of asset class for your time horizon. If you have a long investment horizon then you can afford the risk of owning equities. If you have a very short time horizon then you should probably stay in cash. Anything in between should have some combination of risky/guaranteed investments.
The idea behind choosing the proper investment to your time horizon is not to increase your investment return, but rather to increase the probability that the required amount of money will be there when you need it.
Here are some sample investment time horizon scenarios – please keep in mind that there are no “agreed upon” lengths of time for various term lengths.
Short term – Susan is 25 and saving part of her RRSP to use as a down payment for a condo in the next couple of years. In this case, the portion of the RRSP to be used for the downpayment has a very short time horizon and should not have any stocks or long term bonds. This amount should be in cash or some sort of money market funds.
Medium term – Bob and Gertrude are 33 and want to buy a cottage in about 10 years. In this case they should have some equities but not too much. Perhaps a 50% equity/ 50% cash/short term bond would be appropriate. As they get closer to the potential purchase date, they will want to increase the non-equity portion. Once they get to within 4 or 5 years of the purchase they might want to be 100% cash or short term bonds.
Long term – Johnny is 38 years old, has $100,000 in his RRSP and is not planning to retire for at least 20 years and will probably live another 25 years after that. Johnny can afford to have most of his investment in equities because of his long time horizon. But, he does have to consider other factors such as how well he can handle volatility.
Don’t lump everything together
If you will be drawing from your investments at different time intervals then it is important to separate your portfolio by time frames. If you are retiring in 3 years then consider putting away about 5 years worth of withdrawals into cash. As you use up that cash in retirement you can sell equities to keep up the cash cushion. Since you have 5 years worth of cash, you also have the option of not selling any equities for 5 years – a retiree might choose to wait it out after a year like this one, rather than sell any equities. Younger retirees have several different investment time horizons ranging from short to long, so they need to have a portfolio that reflects that. They shouldn’t have all bonds or all equities.
Similarly, a house hunter who wants to borrow $20,000 from their RRSP should put that money into cash or money market funds. The remainder of their RRSP, however, should be considered a long-term investment and allocated appropriately.