A Tip for Young Investors: Get Your Time Frame Right.

One of the very first things you need to figure out when you’re starting to invest is what time frame you’re looking at.  Are you going to need this money six months from now, two years from now, or 30 years from now? The answer makes a big difference as to which type(s) of investments to use.

In a post a few weeks back, Trent from The Simple Dollar explained this concept using a wonderful analogy for investing:

Think of the stock market as being kind of like a coin flip. Think of each year as being like a single coin flip, where a heads flip will get you a 15% gain and a tails flip will get you a 10% loss. The more times you flip a coin, the more likely you are to get a roughly equal mix of heads and tails results.

Since I’m thirty years away from retirement, I have a lot of coin flips ahead of me. I’ll likely see some runs of heads and some runs of tails, but over that long period, it’ll approach an even split in flips. That even split will mean a pretty good return on my investment.

But let’s say you’re now five years from retirement. That means you have only five coin flips. There’s now a measurable chance (a little over 3%) that all of your remaining flips will be bad, losing you a significant amount of money. Instead of being a volatile investment, it moves more towards being a gamble.

I absolutely love the way he explains this concept. It sums up perfectly why you want to avoid stocks if you’re going to need your money in the next few years (and, conversely, why you want to go heavily into stocks if you have many many years ahead of you).

I do, however, want to highlight something in the analogy that (I believe) is a mistake that many people make when planning their investment strategies.

If You’re 5 Years from Retirement, What’s Your Investing Time Frame?

It’s easy to say “Well, I’m 5 years from retirement, so I can’t afford to have my investments go down. I’d better not use any stocks.” In fact, during my time as a financial advisor, I heard many people say exactly that.

But here’s the problem with that type of thinking: You don’t sell all of your investments the day you retire. Or, to look at it differently, your investing time frame isn’t from now until the day you retire. It’s from now until the day you die. I don’t know anybody who expects those to be the same date. (Edit: I suppose I did have professor in college who always said that he planned to teach until the day he dropped dead in class.)

How About Some Numbers?

According to the National Center for Health Statistics, in 2005 (the most recent year for which I could find data), the average 65 year old was expected to live another 18.7 years. From what I’ve heard and read over the last few years, it seems that most people in our country are seeking to retire by age 60 or earlier. That means that we need to be planning for retirements that are at least 20 years long.

So what’s the investing time frame for a person who is five years from retirement? Well, it’s a heck of a lot longer than five years. It’s probably something closer to 20 or 30 years (or more).

So What Does a 20-Year Time Frame Mean?

Two things, I think:

1. There will be plenty of time for the volatile returns from stocks (or stock-based funds) to level out.
2. It’s likely that cost of living will double (or more) during that period due to inflation. So fixed income investments aren’t going to cut it.

My takeaway from all this? Plan on owning equities (stocks) in retirement. Lots of ’em.

What do you think? What do you think your portfolio will consist of as you approach (and enter, and proceed through) retirement?