Horizon risk: what is it, and how can it be mitigated?

Everyone should strive to be a long-term investor. But we also have different time horizons for different goals and need to be aware of how those horizons change. In the latest in our occasional series on different types of risk we look at horizon risk and ask, Is there anything you can do about it?

One of the most common pieces of financial advice is that you should invest for the long term: don’t worry about what markets do from day to day, because it’s really the return you earn over 15 or 20 years that matters.

This is referred to as having a long-term time horizon. Since you are thinking about your finances well into the future, you should invest in the stock market where long-term returns will be better, even if there is more volatility in the short term.

Generally, this is great advice. Many investors have compromised their wealth by reacting to short-term market movements and buying or selling at the wrong time; or by keeping their money in cash and earning below inflation returns.

However, as a single piece of advice it can also be too simplistic. That is because every investor has a number of different time horizons, requiring different approaches. There is also the risk that your time horizon changes, or that it might suddenly be shortened by something outside of your control.

Matching up

This is called horizon risk — the risk that your time horizon and your investment strategy don’t match.

It’s all well and good to invest for the long term when you are building a pot of money for when you are no longer working. But not all of your financial needs are only going to be 20 or 30 years into the future.

You might, for example, need to invest some money to pay for your eight-year old’s university education. That gives you a defined time horizon of ten years.

It may feel like a decade is a long enough period to be invested in the stock market, and broadly speaking that is true. But next year, your time horizon will only be nine years. And five years from now it will only be five years.

Are those still long enough periods to be able to see out stock market volatility? What if the market is down when you need to start paying university fees?

Shifting horizons

This example highlights how you may need to adjust your investment strategy as your time horizon changes.

If only you need to pay university fees ten years from now, you definitely don’t want to put all of that money in cash where it will lose some value over time because of inflation. You need to give it a chance to earn higher returns, and for those to compound.

But, equally, if you need to pay university fees five years from now, you can’t take the risk of losing half of the capital you have built up because there is a market crash at just the wrong time. You still want to have some exposure to shares so that you earn higher returns if the market is strong, but you also want to protect your portfolio in case of a downturn.

This calls for careful diversification, and taking the appropriate amount of risk for your time horizon.

Emergency!

Another way in which horizon risk can play out is if something happens to dramatically shortened your time horizon.

At the age of 40, for example, you might think that you still have 25 years to save before you stop working at 65. But what would happen if you lost your job? Would you need to draw from your long-term savings to survive?

Not only would that mean you no longer benefited from compounding returns, but you might also find yourself having to sell when the markets are down, locking in losses. This is a real concern, since the most likely time for people to find themselves being made redundant is in a recession.

This is why it’s important to have emergency savings in a short-term fund. This should be able to cover a few months of expenses so that you don’t compromise your long-term investments when bad times hit.

Return, and return

But an even worse scenario would be if you were disabled in an accident or fell seriously ill so that you could no longer work. In such an unfortunate circumstance, the long-term time horizon you thought you had suddenly collapses entirely.

The money you were investing to pay yourself an income 25 years from now is suddenly needed to start covering your expenses right away.

The only effective way to mitigate this risk is to have adequate personal insurance in place. Income protection and critical illness cover are crucial for ensuring that if your investment horizon is suddenly cut short, you aren’t left stranded without sufficient capital.

Overall, managing horizon risk is about balancing the return on your money against the return of your money. When your goals are more short-term in nature, it’s important to make sure you get your money back without losing value. Over the longer term, you want to make sure that you are getting a return on your investment so that it will compound and grow.

But always bear in mind that your horizons change, and you need to both adapt your strategies accordingly, and have protection in place for worst-case scenarios.