Time horizon and risk tolerance: Why they matter when investing

Understanding time horizon and risk tolerance is critical to making sure your money is invested in the vehicles that work best for your specific financial plan. It all starts with knowing when you plan to use the money in your investment account. Your risk tolerance may differ with each investment account, especially if your time horizon is different for the goals associated with each account.

A key part of incorporating time horizon and risk tolerance into your investment approach is dividing your portfolio into buckets, each of which is focused on a different objective. Here are some things to consider when evaluating your time horizon and risk tolerance.

What is time horizon?

Time horizon refers to how long an asset has until it’s expected to grow to its highest value and you plan to use the money. This might be short (zero to three years), medium (three to 10 years) or long term (more than 10 years), depending on the goals of the investment. Allocating assets by time horizon matters: An investment that you don’t need for a decade, for example, can assume much more risk than one that you hope provides a return within a couple of years.

For example, let’s say you’re planning for the future and wondering where to put money you recently inherited from a grandparent. You want to buy a home in the next five years, so you decide to put some of the inheritance into a five-year certificate of deposit (CD) – an account and goal with a medium time horizon. You also decide that you want to have six months’ worth of your salary in a savings account for an emergency fund that can be liquidated easily. The time horizon for that account is short. Finally, you put a portion of the money into a retirement account and you have a long time horizon for that investment.

An investment account with a long time horizon can make aggressive investments because it has plenty of time to recover from downturns (though investment returns are never guaranteed). The money set aside for a medium-term goal doesn’t have the same luxury, as it may need to mature over the next five years or so. Anything needed even sooner, such as an emergency fund, may be better suited to a money market fund, money market account or a high-yield savings account, which are generally more liquid.

Multiple time horizons can come into play for different goals. This is why it could make sense to allocate your money to “buckets” for separate objectives and their corresponding investments. As each bucket approaches its time horizon – and hopefully generates positive returns – you can figure out how to liquidate the assets related to your specific goals.

What is risk tolerance?

Risk tolerance is how comfortable you are with uncertainty and volatility. Think about how you feel when markets take a turn for the worse: Do you panic or stay calm? Do you feel the urge to sell or do you stay focused on your investment strategy?

If you’re comfortable sitting tight because you know you’re in it for the long haul, you may have a high level of risk tolerance. That’s good for long-term investments, which may experience market ups and downs. For example, stock market returns can be positive or negative on a monthly or even yearly basis. If you invested in an index fund that tracks the stock market, you may see monthly or yearly volatility with your returns. But, if after 10 years, the average return is positive, then your investment weathered the storm. A long time horizon and a high risk tolerance may help you net positive returns and benefit from compound interest.

Conversely, if you get nervous when markets are down, you may have a lower risk tolerance. That may serve you well with shorter-term investments because you can opt for safer and more liquid accounts like a money market fund or money market account. But with long-term investments, a lower risk tolerance could mean avoiding riskier funds with the potential for higher returns – which could cause you to fall short of your long-term savings goal.

It’s worth noting that risk tolerance is not the same as risk capacity, which refers to your ability to lose money on an investment. You might feel OK investing in a volatile stock, but can your finances afford to lose money if the company folds?

If your risk tolerance is above your risk capacity, you’ll need to take extra care not to overextend yourself. If it’s the other way around, you may find you gravitate toward overly conservative investments, even when you have a long time horizon.

How time horizon and risk tolerance work together

Even if you have a naturally low risk tolerance, there are ways to invest so that you can hit your long-term goals without completely changing your approach to risk. For example, a target-date fund is managed to maximize returns for a set date without your having to keep an eye on it. This type of investment could match well with your risk tolerance.

Comparatively, a high risk tolerance may not work well with a short-term investment since you could end up losing money that you need for a short-term goal. Keeping the money in cash in a liquid account that’s insured, like a money market account or a high-yield savings account, might make more sense.

As with our earlier example, an emergency fund may be used for a short-term goal, which could mean it’s better suited for a low-risk fund or account. Money for a down payment on a house may be able to withstand some market volatility if you don’t need the money for five years. And a retirement account could benefit from a higher risk tolerance since it has a long time horizon and you don’t need that money anytime soon.

It all depends on your financial situation, risk tolerance, risk capacity and goals. Consider talking with a financial professional to discuss all of your investment options, from savings accounts and CDs to bonds, stocks and funds, for your different buckets of money.

Asset allocation and rebalancing your portfolio

Knowing how to allocate your assets means taking both time horizon and risk tolerance into account. For example, depending on your situation, index funds may be a better investment for a long time horizon, whereas bonds or cash equivalents may be better for required returns and shorter time horizons.

Every time you reach a goal or your time horizon for an investment is near, it’s wise to rebalance your portfolio. For example, if your portfolio was 80% stocks and 20% bonds, you could shift it to 80% bonds and 20% stocks as your goal approaches, taking on less risk as you aim to retain more of your earnings.

There may also be market movements to stay on top of: What was once risky may not be anymore, and vice versa. You may need to keep your portfolio and all your buckets updated to reflect your personal circumstances, changes in risk capacity and wider market issues.

Common mistakes and how you can avoid them

Most common problems center on a misalignment of time horizon and risk tolerance – that is, being either too aggressive for short-term goals or too conservative for long-term goals. That’s why dividing your resources into different buckets for specific goals is so important. And as always, avoid trying to time the market – it rarely works well for anyone.

Don’t forget that just as there are changes in markets, there are also life events to consider. If you decide to have a child or suddenly lose your job, your portfolio may need to change. When planning for a child’s future, you might want a new bucket for a college fund. If you lose your job, you may pull back on contributions to investment accounts until you land a new role.

Determining time horizon and risk tolerance: Some questions to ask yourself

When evaluating your time horizon and risk tolerance, you can ask yourself the following questions:

The bottom line

There’s no one-size-fits-all approach to investing, so you need to analyze your own situation and goals carefully. Consider what goals you have and organize your asset allocation by timeline accordingly.

Consider the time horizon for each investment and how high your risk tolerance and risk capacity levels are. A diversified portfolio divided into multiple buckets allows you to balance these factors appropriately. For more guidance, a J.P. Morgan financial professional can help you create the right investment portfolio for your goals.

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