Investment horizon is the total length of time that an investor expects to hold a security or a portfolio. The investment horizon determines the investor's income needs and desired risk exposure, which aid in security selection. Establishing an investment horizon should be one of the first steps to creating a portfolio.
As investment horizons increase in length, equities represent a higher risk-adjusted return than fixed-income securities and cash. Across shorter investment horizons, equities become the riskier asset class because they carry higher levels of volatility. For example, a young professional with a 401(k) plan should be mostly invested in equities because this person's time horizon could be 30 years or more. For someone nearing retirement, however, preservation of capital becomes much more important, so fixed-income investments become more attractive. Some trading strategies, especially those based on technical analysis, can employ investment horizons of days, hours or even minutes.
To establish proper diversification, an investment portfolio should consist of multiple asset classes. For a longer investment horizon, more risk can be taken, since the market has many years to recover in the event of a pullback. Longer-term investment horizon portfolios, especially over 10 years, should have most of their allocations dedicated to equities. Within equities, a larger part of the portfolio can also be allocated to riskier asset classes, such as mid-cap, small-cap and international stocks. Typically, long-term investment horizon portfolios should have a range of 70 to 100% in equities with the rest in fixed income.
As the horizon reduces, the portfolio should be adjusted accordingly; more of the portfolio should move from equities into fixed income. Fixed income provides less return over the long run but increases stability of principal in the portfolio. Mid-term horizon portfolios should have an allocation of 30 to 70% in equities with the remainder in fixed income.
When approaching the end of the investment horizon, the portfolio should be allocated to mostly fixed-income investments to minimize risk. This protects the portfolio from a major pullback in the equity markets and maintains the principal amount. Short-term investment horizon portfolios should maintain an asset allocation of 70 to 100% in fixed income and the rest in equities.
Some investments have their own time horizon based on their structure. Stocks are considered to be optimal for longer-term investors, with small-cap stocks being the most risky. A bond has a maturity or call date associated with it. Once that maturity or call date is reached, the investor gets the par value of the investment. Certificates of deposit (CDs) also work like bonds in that they are based on a maturity date and the investor receives the original par value.
An annuity, especially a fixed annuity, has a set amount of time when the insurance company pays a specific interest rate to the annuity owner. Once that time expires, the owner can either stay with the newly adjusted interest rate or surrender the contract.