What do we mean by short, medium and long-term time frames?

Jason Baran, Insight Analyst (Investments)

Financial journalism often makes mention of “short-term price movements”, “investing over the long-term” and the like. But what does this actually mean? How long is ‘long-term’?

There are two important perspectives to cover here – that of a retail investor, and that of a fund manager. We shall cover the perspective of retail investors first as this is most pertinent to Defaqto’s clients, who are more likely to be approaching investing with less experience than an industry professional (we hope!).

For a retail client, quite simply, investment time-frames refer to when an investor will expect to withdraw their original investment. This can vary depending on the objective of the investment, for example saving for retirement can have a time frame of 40 years for a client in their early 20s just entering the work force. Similarly, it doesn’t take a nobel prize winner to know that the time frame for a 60 year old also saving for retirement will be significantly shorter and measured in a handful of years. Other objectives may also be required, such as savings for a first time buyer house deposit, or saving for a child’s university education.

While the above time to retirement calculation is stating the obvious, this time-frame forms a significant constraint on the level of risk an investor can take. When investing, we know that there is risk and that we expect to be compensated for that risk by a return on our investment. This obviously means that the return of an asset will vary over time and there is always a chance we could get back less than our original investment. We want to invest long enough that the return of an asset realises the expected return, but not so short that the return is effected by random volatility.

In practice, this requires longer time horizons for riskier assets, i.e. we need to invest for a longer period in order to achieve these greater return rates. Looking at the riskier end of asset choices, equities display the greatest volatility and form the bulk of investors’ portfolios for generating high returns. Looking at the typical cycle of bull and bear markets and economic cycles, a 7-10 year time period is recommended to ride out any drawdowns and unforeseen economic recessions. The use of dollar cost averaging can also help by smoothing out peaks and troughs and enabling the investor to receive the long-term return rate of a market.

For time periods shorter than this, an investor will need to make greater use of fixed income assets within their portfolio. Risk can be lowered as a bond requires a borrower to return the face value to the investor at maturity (contrast with equities where no future value is certain). Again the time horizon of the investor will influence the level of risk, with choices of government vs. corporate bonds and varying lengths of bond maturity.

Accordingly, time horizons that allow an investor to invest in equities are ‘long’, those when risk is very limited are ‘short’ and those in between are ‘medium’. To be most specific, long is >7 years, short is anything <3 years, and medium rather between the two at around 5 years.

Moving onto our second perspective of a fund manager or industry professional, the time horizon will depend on the strategy and objective of the fund. For a traditional long-only equity fund, a fund manager should invest along a similar long-term horizon of 7-10 years or longer, e.g. Warren Buffet who believes in investing in companies for an infinite period.

Other strategies may employ shorter time periods. Taking to the extreme, high-frequency trading (HFT) and some arbitrage strategies employ time periods that may last only a few seconds or minutes. Similarly, event driven investing strategies that focus on corporate actions or central bank decisions may have horizons of <1 year for their positions. Hence what is short-term volatility for an equity investor may well be the alpha generation for a fund operating one of these other strategies.

This variety of time horizons depending on strategy, and frequency of reporting from the fund manager’s perspective, is what drives the confusion of time horizons for retail investors. Hence while it is interesting and possibly educational to read market commentary regarding these other strategies, retail clients should always remember what their own investment objectives are and the time horizons that are required. This will enable them to focus on their goals and not be distracted by market ‘noise’.