Long-term versus Short-term Investments
Putting a timeline and goal amount for your investments matters because the strategy you take to invest for the long term is very different than if you are investing for the short term. Take that new home that you are getting in 5 years: you should have a very different portfolio for it than for your retirement portfolio that you’re cashing out in 25 years. Goals with a time horizon of less than 3-5 years can be considered short-term, and the ones above 5-7 years can be considered medium- to long-term.
The differences in portfolios come down to how risky and how liquid the given portfolio should be. The riskiness and liquidity is a function of an investment portfolio’s combination of stocks, bonds, real estate, and other assets.
When do you want to use the money you’re investing? Do you want it in 1 year? 5 years? 30 years? Once you determine your timeline, here are the two main things you need to yourself before you start investing:
Are you taking the appropriate level of risk given your timeline?
As shown in Figure 1 below, there’s a clear relationship between risk and average returns in the long term. But, the key words here are “long term” and “average”. In the short term, riskier investments fluctuate more and therefore can give much higher returns or much lower (negative!) returns than lower-risk investments: a short-term investment in a high-risk asset may end up in a significant loss at the time you were planning to liquidate the investment to pay for the goal you were targeting. If you’re getting close to wanting to use the money, you don’t want to risk those negative returns, so you should decrease the risk of your investment portfolios.
Just as you don’t want to be in a risky portfolio in the short term, you don’t want to be in an excessively safe portfolio for the long term. A long-term-focused investment in a very low-risk asset will end up in a significant missed opportunity. Consider this: an extra 2% annual return in 30 years gives 50% more capital (think: $3 million USD for your retirement instead of $2 million USD!).
This being said, too much risk is a mistake, but too little risk can also be a mistake. However, time horizon isn’t the only factor when determining how much risk you should take. To be able to sustain any investment, it’s crucial that you are comfortable with the risk level you opt for. Adjusting for your tolerance for risk is one of the key ways to personalise your investments.
Do you have sufficient liquidity?
A liquid investment is an investment that can be sold quickly into cash at a low cost and with certainty. For example, Apple’s shares are very liquid, while an apartment is not liquid. The former example can be sold in a matter of minutes when the stock market is open, while an apartment may take months and significant costs to be sold at the right value.
Why is liquidity important? How liquid an investment is determines how easily you can convert it into cash, ultimately to pay for a goal you’ve been saving for. If you tie all of your money up in an apartment, you could find yourself waiting longer than you wanted for the sale to turn into spendable cash.
Emergency funds should generally be kept partially in cash, as cash is the most liquid possible asset, and partially in investments you can liquidate in less than 3-4 days as you never know when you’ll need to pay for a hospital bill or broken refrigerator. Similarly, for short-term goals, make sure they are invested in liquid instruments so that you can easily spend the money exactly when you need to attain the goal, versus waiting possibly months for it.
Make sure your investments have a timeline
It’s important to put a timeframe on your goals to determine how much risk you should assign to your various investments. Simply put, if you invest for the long term, you can afford to take more risk and invest in less liquid asset classes (think: property); in the short-term, you need to invest in assets that are less risky and highly liquid.
You can have parts of your long-term portfolio invested in more illiquid asset classes. In the long-term, you can afford to have a mix of liquid and illiquid instruments and maximise your long-term returns.