When you want to make a decision regarding what investment product to buy into, one of the first questions that you should answer is “what is the time horizon?” This is important because investment products are suited to different time horizons i.e. the length of time an investment can be held before it’s liquidated.
If you are investing for the purpose of sending your kids to college in 16 years’ time, that’s a long-term. If you are saving to purchase a car in the next one-year, that’s a short-term. Clearly, based on the understanding that financial markets are volatile different approaches should be adopted in handling your investment to meet both goals.
However, what typically happens is this, some people would have saved some money for several months to pay their rent in a couple of month. But because they are seeing in the news that the stock market is rallying, they start to inquire about what stocks to buy. Now that’s the beginning of trouble. The stock market can be particularly volatile in the short-term in reaction to changing moods and expectations. There’s no telling if the market would witness a correction in the weeks before the rent is due and the investment is down some 15%.
Think about it, what you do when you rent becomes due and find that your stocks are down 20%?
As such, when choosing how much money to invest in the stock market, it’s important to consider how long it will be before you need that cash.
The following parameters should be used when deciding the smartest, safest and most profitable place for your savings:
- Short Term: Any money you will need in less than 5-years, should be in near cash investment products such as Treasury Bills, Commercial Papers or Fixed Deposits.
- Medium Term: Any money you will need in the next 5-10 years, should be invested in a mixture of stocks and bonds. A balanced mutual fund is ideal.
- Long Term: Any money you will need in more than 10-years, is eligible for investment in an aggressive stock portfolio.
When you invest with funds that you have no immediate need for, you protect yourself from the short term fluctuations of the stock market. The stock market can be quite volatile in the short-term. However, holding your investments for a long time allows the fluctuations to be smoothed out. That’s why you should invest with a 5-10 year timeline in mind. This will prevent you from pulling your funds out in a downturn and incurring a loss.