Investing when you have a short time horizon
Written by Preet Banerjee
Wednesday, September 23rd, 2015
Recently I was chatting with some soon-to-be post-secondary graduates about their short-term financial goals. A number of them identified saving up for a down payment on a home within the next five years as a major goal.
Intended to be an easy, softball question, I asked them what kind of savings or investments they would use for their down payment funds. I was expecting all of them to come up with various, short-term, low-risk options like GICs and high-interest savings accounts. I was surprised to find that many were planning on buying individual stocks, or higher risk investment funds.
"If you take on more risk, you'll get more return" was a common explanation.
I've heard the above statement made fairly often, and I'll cut to the chase: it's wrong.
If you're only mildly familiar with the concept of risk and return, the above quote might seem like an innocuous statement, but in reality it's a very dangerous misperception. There is a subtle clarification that is very important when discussing risk and its relation to return: taking on more risk only offers the potential of higher returns. Further, you need a long time frame before you can really start to feel confident about the risk and return tradeoff, and that's assuming you have a properly diversified portfolio (a handful of stocks is not a properly diversified portfolio).
Over the short term, it's possible that a higher risk portfolio will leave you with a larger down payment fund than had you invested in something safe that had a lower potential return. That could lead you to be in a position to buy a home sooner, to have a smaller mortgage, or perhaps to look at a more expensive home. But it's also possible that things work out in the opposite direction, that the higher risk portfolio loses money during the five years it's invested. That would have the opposite effects of delaying buying a home, having a larger mortgage, or being forced to look at lower cost homes.
I decided to reframe the question.
I asked the students if they would rather have a guaranteed $35,000 in 5 years, or the possibility of somewhere between $25,000 and $45,000? The numbers started to shift to the lower risk options and the guarantee of $35,000. But not everyone was on board yet.
Then we went one step further. We calculated how much house they could afford based on 5% down payments that were either $25,000, $35,000, or $45,000. They had fun with the high down payment options, but were very put off by the low down payment options. In fact, they were more put off by the low down payment option than they were excited about the high down payment option. This jives with a well-known concept from behavioural finance known as "loss aversion" — we are generally twice as sensitive to losses than we are to comparable gains.
After running through this little experiment, almost everyone agreed that the most prudent approach for short time frames was to use lower risk approaches like GICs and high-interest savings accounts. The thought of missing out on being able to afford their ideal first home was stronger than the possibility of scoring a slightly better home.
With longer time horizon goals, such as saving for retirement, the short term unpredictability of riskier portfolios are more likely to yield higher long-term returns than safer alternatives.
But one final note: just because you may have a long time horizon doesn't mean you have to take on a lot more risk. Another critical component of investing success is to truly know one's self. If you're simply less comfortable than others with fluctuations in your account, you don't have to turn the dial from 1 to 10 when going from short-term investing to long-term investing. Perhaps you only move it to a 5. And that's OK. If you're more likely to stick to your strategy with a moderate portfolio, but you might abandon a more aggressive portfolio when the going gets tough, the moderate strategy might end up with the larger account value for you in the long-run.
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