The two key simple questions of investing are:
- What’s the purpose of the investment?
- And what’s the timeframe?
Work out the answer to these questions and you can then target where you should invest your money.
During conversations I have with all types of investors, they often describe an investment they’ve made. I typically then ask them why they made the decision to purchase the asset. Frequently, they don’t really know and often respond vaguely by saying they were simply trying to build their wealth.
Some of the unsaid purposes might be to protect them if something untoward happens – for example, health or family problems or a business suffers from poor trading or the loss of their job.
But assuming the money isn’t needed to cover for these financial snafus, then its next purpose might be vaguely designed to pay for weddings, school fees or the myriad of other expenses that might come their way.
And finally, there is the need to fund retirement and possibly a bequest for our survivors.
While in theory it’s fine to want to build wealth with no definite purpose, you’ll have greater success in your investing activity if you can be more definite about your investment timeframes.
Time is money
Building wealth over an indefinite timeframe doesn’t help you work out what type of asset you can buy and what characteristics that asset needs to have. Depending on who you are, this will mean you either under, or over, estimate the risks of buying a particular type of asset.
One place you won’t get good guidance about investment timeframes is general financial literature.
Typical investment timeframes are as often defined as follows:
- Short investment timeframe – One to three years.
- Medium investment timeframe – Four to six years.
- Long-term investment timeframe – Seven or more years.
Within these timeframes, some financial literature argues that medium-term investors can put up with a 20% change in the value of their investments in a year and long-term investors can have their capital value go up or down by 40% in a year.
The danger with these assumptions is that they’re based on constant average returns. For example, there might be an assumption that listed shares increase on average, after fees and charges, by 8% each year.
There are two problems with this approach – firstly, they combine the income and the capital returns from these investments (this is done by incorrectly adding the average annual increase in the value of shares of 4% with the average annual yearly dividend payment of 4%).
Secondly, we all know that the returns from investments rarely, if ever, deliver an average return. Basing your investment outcome by relying on average returns means you’re highly likely to be wrong.
The risks
In my view, these typical timeframes dangerously underestimate the fluctuations in values for all types of assets.
We can never predict the future sale price we will receive for an asset. We might be able to make an educated guess but that’s all it will be – a guess. In addition, in the vast majority of cases, we will have no control over the price we will receive.
This ultimately means that any price fluctuation just before we sell an asset is a very dangerous time if the price we receive is essential to deliver us a reasonable rate of return.
No one wants to be a forced seller in a depressed market.
The reality is that the longer the investment timeframe, the less important is the fluctuation in investment prices. For this reason, my preferred investment timeframes are the following:
- Short investment timeframe – less than 10 years.
- Medium investment timeframe – between 15 to 20 years.
- Long-term investment timeframe – at least 20 years.
Those with a short investment timeframe should avoid assets that potentially fluctuate wildly. Medium and long-term investors need to very carefully watch the value of their investing assets as their investment timeframe moves to less than 10 years.
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.
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- Charlie Aitken: Buy US dollar exposure [2]
- Ron Bewley: The yield portfolio’s first risk assessment [3]
- Tony Featherstone: Takeover talk – eyes on iSelect [4]
- George Lucas: My SMSF: a fondness for flexibility [5]
- Staff Reporter: Buy, Sell, Hold – what the brokers say [6]
- Questions of the week: The ABCs of LICs and ETFs [7]