When it comes to money and divvying up your assets, time is either on your side or it’s not.
What types of assets you should invest in has more to do with when you’ll need the money and what your goals are, and less about your risk tolerance or outlook for stocks or the economy.
“The closer you are to a financial goal timewise, the more protection you want for your principal,” says Roger Young, a senior financial planner at T. Rowe Price. “You want a high probability that the money will be there.”
In contrast, “The more time you have, the more you can afford to take risk,” adds Brad Bernstein, managing director at UBS Global Wealth Management.
There’s a time-related sweet spot for every type of investment, whether it’s stocks, bonds, or a bank savings account. Why? There’s a hard-to-ignore relationship between risk and how quickly you need to access your money.
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If you must withdraw your money tomorrow for a specific reason, such as a home down payment or financial emergency, you want your cash in the most conservative account you can find. Think cash. CDs. Money market accounts. Short-term bonds.
But, if you’re saving for retirement or your newborn’s college tuition, and you don’t need your money for 10, 20 or 30 years, you’re better off investing in riskier, higher-return assets like stocks. While stocks have a much higher probability of losing value in short timeframes, the longer you hang on to them, the odds of losing money drops dramatically – even to zero in some cases.
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Stocks purchased and then held at least 10 years, for example, posted negative returns just 5% of the time from 1926 to 2018, according to Fidelity Investments. In contrast, stocks held for only one year fell in value 25% of the time.
“In the stock market, in a one-year period there’s a very real chance you can lose money, and it can be a significant loss,” says Young.
Another way of looking at risk is to weigh worst-case scenarios. The biggest decline for a one-year holding period for stocks was 37%, measured by real total return – which includes reinvestment of dividends and adjustments for inflation – according to The Measure of a Plan website. In contrast, the worst return stock investors had over a 20-year holding period was a gain of 0.5%.
Cash, of course, is risk-free when it comes to protecting the principal. And owning investment-grade bonds, which have a low chance of default, are also far less risky, as a one-year holding period only resulted in losses 12% of the time; odds of a negative return drop to 1% with a holding period of three years and zero if you hold for five years or more, the Fidelity data show.
That’s why your “investment time horizon” should be the driving force behind how you diversify your money among different types of assets.
“Time frame, to us, is the most important variable when recommending an asset allocation to a client,” says Bernstein of UBS.
THE BUCKET APPROACH
Bernstein points out, however, that nobody – or no family – has just one time horizon.
Practically speaking, whether you’re single or a household of four, you’re going to have multiple financial goals, all with different time horizons and account types and holdings.
You might, for example, have a 401(k) earmarked for retirement in 20 years loaded with stocks. Your spouse might have an IRA. You might have two different 529 college accounts, one for your fourth grader with a healthy helping of stocks and another for your high school senior that’s mostly in bonds. You might have an emergency fund sitting in a money market account at your local bank, or an online brokerage account where you’re saving for other stuff.
All those different goals and timeframes mean your money needs to be broken up into what UBS calls “buckets.”
“We believe in the bucket approach,” Bernstein says. “The goal is to have multiple investment strategies that achieve different goals.”
Having a mix of buckets, some filled with nothing but cash or other risk-free investments, others with a diversified mix of bonds and cash, and others focused mainly on riskier investments, such as stocks, ensures that you’ll have access to the money you need when you need it. And, more important, never have to sell your stocks in a down market.
That’s “the last thing you want to do,” says Ruth Transue, a senior financial advisor at Wells Fargo Advisors.
A retiree, for example, may have three buckets. One bucket with cash to meet living expenses for up to two years. Another bucket made up of fixed-income investments, such as bonds, to provide income to live on. And a third bucket, made up of stock funds or alternative investments, designed to grow wealth for a long lifespan or to pass on to heirs.
People in their 20s, 30s, 40s and 50s who are in the “accumulation” stage, Bernstein adds, might have many more buckets, including many targeting long-term goals: “They have many different needs and may have 10 different accounts. The more time you have, the more money that should be in stocks.”
T. Rowe Price now recommends that at the start of the investing lifecycle for retirement, savers should have 98% of their money in stocks, and dial that back to 55% in retirement to take longevity into account and boost their chances of not running out of money. Similarly, Vanguard’s target-date funds, which get less aggressive as you near retirement, now hold about 50% stocks for current retirees, about 60% for people retiring in five years and nearly 89% for people retiring 30 years from now in 2050.
WHAT TO OWN BASED ON YOUR TIMEFRAME
If you need your money in …
One to two years – This is money that you can’t put at risk – ever. “These types of investments are intended to preserve principal,” says Young. If you need the money for an emergency or a down payment on a home you’d like to buy next spring, the money has to be in an account that allows you to access the cash quickly and easily – and without fear that the account balance will be lower due to a market downturn.
“You want the money in a pretty safe investment,” says Young. “An insured bank account is an obvious choice. Other options would include a money market account or a short-term bond fund.”
Having a cash “buffer” is important to everyone, but especially retirees who need cash on hand, so they won’t need to withdraw funds from their 401(k)s in a down market, says Transue. For example, as part of the financial plan for a divorced woman in her 70s, Transue built up a cash cushion of a year’s worth of living expenses and put it in a money market. That enabled her client to stop drawing income from the investment portion of her portfolio during the recent bear market. Transue recommends that people within two years of retirement start building up a similar type of emergency fund.
- Five years – From a time horizon standpoint, five years isn’t a long time. So, stick to more conservative investments, Young advises. “You probably don’t want a lot of stocks,” he says. Low-volatility investments that generate income, such as short-term bond funds that mature within five years and corporate bonds with a low chance of default make the most sense, he adds.
- Five to 10 years – Money you need within a decade should be invested in a diversified menu of investments, including stocks, bonds issued by the U.S. or corporations, and a cash stash for emergencies. It’s a more balanced approach. Spread your investments around, and own both large- and small-company stocks, international shares, as well as growth and value stocks, Young says.
- 10 or more years – “Ten-plus years is a reasonable way to think about the long-term,” Young says. And that means buckets with this much time on their side should be mostly invested for growth.
“For a longer time horizon, you want to focus on stocks that give you growth potential,” Young says.
This article originally appeared on USA TODAY: Looking to invest? Here's how to diversify your portfolio based on when you'll need money