Goal and time horizon
First comes the question of when you need the money, then the question of how to invest it. Money you need in two years doesn't belong in investments that swing a lot.
Learning objective: After this lesson you can set a time frame for each savings goal and choose a matching way to invest it.
Every euro you put aside has a date. The car repair might come next year, the new kitchen in five, retirement in thirty. Each of these dates suits something different.
A rough rule of thumb:
- Money for the next three years stays safe and quickly available.
- Money for three to ten years can be invested in a mix.
- Money you won't need for more than ten years can handle swings.
The reason is simple. Prices swing, and the shorter the time, the greater the risk that you need the money right in a slump. Tobias puts €20,000 for the deposit on a flat into stocks, planning to buy in two years. If the market falls 30 percent in the second year, he's €6,000 short, and the flat won't wait.
Write down your goals, each with an amount and a year. That list is worth more than any stock tip, because it answers the question that really matters: what the money is for.
The numbers show why time matters so much. The expected return grows steadily with each year. The swings, measured as standard deviation, only grow with the square root of time. So the chance of ending up at a loss falls the longer you stay invested, even though the range of possible outcomes gets wider overall.
That doesn't mean stocks become safe over time. There have been periods of ten years and more in which investors were at a loss after inflation, for example after 1929 and after 2000. A long time frame mainly lowers the risk of having to sell in a slump and gives compound interest time to work.
In practice this leads to pots by time instead of a single portfolio. Each goal gets an amount, a date and a matching way to invest. Along the way it also answers the question of your equity share: it follows from the sum of your long term goals, not from a general recommendation.
Summary
- First the date, then the way to invest.
- Money needed within three years doesn't belong in volatile investments.
- A long time frame doesn't make stocks safe, but it lowers the pressure to sell.
Did you get it?
Why does the risk of a loss fall the longer you invest?
Because the expected return grows steadily over time, while the swings only grow with the square root of time.
Are stocks safe after ten years?
No. There have been decades with losses after inflation. A long time frame only lowers the risk of having to sell in a slump.
What determines your equity share?
The sum of your long term goals, not a general recommendation.
Check your understanding
Sources and further reading
- Robert Shiller's (Yale) freely available historical market data go back to 1871 and show that there have been decades with negative real stock returns, for instance after 1929. View source ↗