Time horizon

In a previous post, we talked about asset allocation for retirement. To design an asset allocation for a financial goal for an investor, we need to understand time horizon of the goal and risk capacity for the investor. In this post we will talk about the concept of time horizon. Using time horizon, we can arrive at asset allocations for different goals. In another post, we will talk about risk capacity for the investor.

Time horizon is the length of time in the future from today that a significant amount will be withdraw from the portfolio. For example, in 5 years I will buy a car or in 18 years I will start paying for my child’s first year college tuition.

Recall the target year funds and the 110 rule from this post. We can use the year that the withdraw will be made be the retirement year and choose the matching target year fund. Alternatively, using the 110 rule, we can calculate a “fake” age. Let X be in number of years the first significant withdrawal will be made, then

$$ fake\_age = 65 - X $$

Thus,

$$ stock\_percent = 110 - fake\_age \\ bond\_percent = 100 - stock\_percent $$

For example, in 18 years I will start paying for my child’s first year college tuition.

$$ X = 18 \\ fake\_age = 65 - X = 65 - 18 = 47 \\ stock\_percent = 110 - fake\_age = 110 - 47 = 63 \\ bond\_percent = 100 - stock\_percent = 100 - 63 = 37 \\ $$

Therefore, the asset allocation is 63% in stocks and 37% in bonds.

In summary, we use the time horizon of a financial goal to choose a target year fund or alternatively, to design an asset allocation of the portfolio.