Updated: Nov 29, 2021
When you invest your hard earned cash, there are two questions you should ask:
When do you need this money back? This is your time horizon. Is it next week, one year, or ten years or more? In the investing world, long term is generally 10 years or more.
How much risk can you take? Risk is usually thought of as market value fluctuation. What does that mean? If you invest $1 million in a stock, today it could drop down to $800k next month. That is a 20% fluctuation down. This is not uncommon with an individual stock. Alternatively, that stock could increase to $1.2 million. How does this make you feel? Does a $400k range from low to high churn your stomach? Or, does a long term average return of perhaps $70k a year over 15 years on your original $1 million investment sound compelling even with those large changes in value.
For most individuals, the risk isn't the actual market value fluctuation, but whether they call their financial adviser in Champaign, IL and ask him to sell the investment after it drops to $800k. If your wealth manager does his job, he will ask you to recall the conversation about market value fluctuation (also known as risk) we had before your initial investment. And, you will recall that conversation and remember the 'safe cash' your investment adviser had you set aside in your savings account. Then you will go back to your golf game, wine magazine, or road trip and not take any action. Why? For most individual stock investments, a time horizon of 10 years or more is recommended. This long time horizon improves your chances of a higher return.
What if you have saved up $250,000 to pay college tuition for your kids during the next four years? Well, that means you have a time horizon with obligations during years 1, 2, 3, and 4. Due to that short time horizon, and the necessity to pay those college bills, you probably don't want to risk 20% market value changes. Your financial adviser will suggest a conservative investment. Perhaps one where the value cannot go down, but you may earn a 2% return each year ($2k per $100k invested). Your wealth manager in Champaign, Il may advise you to keep $50k in a checking account and then invest in 4 certificates of deposit (CD's) with $50k each maturing at the end of the next four years.
Balancing risk on the Time Horizon
For obligations that are near term and cannot be avoided, you may desire a lower risk and accept a lower investment return. For obligations that are 10 years or more in the future, accepting higher changes in market value can lead to higher investment returns.
In addition to time horizon and risk, you should always check with your financial planner or wealth manager to find out if your investment has liquidity.
Liquidity is the ability to immediately sell your investment and convert it back to cash.
There are some investments that may have a lock up period, meaning you can't get your cash back for at least two years or longer. In some cases, this illiquid investment can earn you a higher return, however you need to be certain that you understand at what point your investment can be sold and when get your cash back.
There are some investments such as very risky bonds where the liquidity may be impaired, meaning there are no buyers for the bond today. But, there might be in three months. Selling an illiquid investment can lead to a higher loss or higher transaction costs.
Make sure your investment advisor discusses time horizon, liquidity, and risk in the context of your financial plan and potential investment returns. Have this conversation before you make an investment decision.
Need a second opinion? The Peak Wealth Planning team can assist. Schedule a call to learn more today.
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About the Author
Peter Newman is a Chartered Financial Advisor (CFA) and president of Peak Wealth Planning. He works with individuals nationwide that have accumulated wealth through company stock, ESOP shares, real estate, or running a business. Peter applies his unique background to help clients achieve their specific goals and enjoy peace of mind.
Peak Wealth Planning provides concierge services to meet your wealth management needs. Services include: financial planning, investment management, esop diversification, retirement income, insurance and estate planning advice, Peak Wealth Planning is a fee only financial advisor based in Champaign, Illinois.