Investors Should Mark Time Horizon

The past eighteen months have been difficult for most investors.

Financial markets have been volatile for a variety of reasons. Anxiety seems high and confidence appears weak. But responsible investment professionals are offering the following general advice to individual investors: build and maintain a well-diversified portfolio focusing on the long term.

Know your time horizon. When individuals are able to understand their own time horizon as well as that of their investments, their anxiety level generally declines.

Moreover, when the objective is to maintain and/or provide for your future standard of living, it helps to know something about your life expectancy. Whether you are in the family formation years, peak earning and investing years, or in retirement, most individuals have a longer time horizon than they think. To illustrate, even at the retirement age of 70, increased life expectancy is reflected in the recent IRS mandate — which changed the minimum distribution time period for qualified retirement plans from 15 to 26 years.

Other aspects of time horizon include differentiating short-term and long-term. For investors, long-term is usually three to five years. Today’s environment seems focused on three to five minutes. To illustrate, with at least three full-time media networks covering financial news, investment has become entertainment. Information overload is the byproduct. When talking heads or video screens provide estimates of top line growth, margin contraction/expansion, and acronyms like EBITDA, p/e, p/s, p/b, and peg, does the individual investor understand what they mean, when they are good or bad, and in what time frame are they appropriate?

Investment is work, not entertainment.

Develop your risk tolerance. Investors want to make money and not lose money. A simple concept, but a bit more difficult to implement. The objective is to develop a risk tolerance that is acceptable for your expected return. Because risk and return are positively correlated, this task requires some knowledge of expected returns and the risks associated with those returns (within your time horizon).

How do we measure returns and risks and what should you expect? For fixed income: If I loan you money, I cannot spend it, so I must forgo consumption. If inflation depreciates the value of the money while you have it, then I will have less purchasing power at repayment. If you cannot repay the loan, I may also lose my capital. This means I need a proxy for consumption, inflation and business risk; in other words, an interest rate.

For equities: I want my capital to share in the business fortune of the company, which will depend upon my ability to assess their ‘going concern’ prospects. Although past performance is not a guarantee of future performance, historical returns do give some perspective.

In everyday conversation, when most people refer to the market, they mean the Dow Jones Industrial Average. Its return has been 16.07 percent over the past five years, 15.14 percent over the past ten years, and 12.83 percent over the past twenty years. The Dow may or may not be a good proxy for equity returns.

Exercise Patience. We all seem to be seeking certainty in our uncertain situation. Information overload and media exposure increase our confusion, rather than clarify our questions.

We want and expect immediate answers and solutions to our problems. To illustrate, ‘Will the Dow reach 20,000?’ The answer is yes, the question is when. Because investment is a long-term proposition, patience is a prerequisite. In fact, investment may seem boring to those looking for action in a society punctuated by instant messaging.

Ask for Advice. Can I do it myself? The answer is always — “Yes, of course you can.” How well may be another matter.

Most of us are not automotive engineers, yet we drive cars. We are not systems engineers, but we operate computers. For the most part, we take our cars and computers like they come, we don’t attempt to build or modify them ourselves. In other words, we are accustomed to using expertise. Investment management is serious business, seeking qualified professional advice is smart business. It is constructive to know when to seek and use advice.

Mary Ann Greenwood, Ph.D., CFA, is president of Greenwood & Associates Inc. in Fayetteville and a board member of the National Association for Business Economics.