Time horizon and Risk 

By Bob Peters || June 23, 2024

The importance of knowing the difference between Accounts and Investments 

I recently had a great conversation with a young lady who participated in her employer’s health savings account (HSA). She planned on letting her contributions in her HSA account grow to cover her later in life health care expenses while paying for her current health care expenses through her other earnings. The plan was to let her HSA grow to a level where distant future health care expenses could be covered from this account…20, 30 and 40 years into her future. She had been contributing to her HSA for several years and was surprised to have recently learned that there were “investment choices” other than cash. Since her intent was to utilize these funds many years into the future it made sense for her to switch her investment options from cash to a low-cost diversified equity Exchange Traded Fund. She was not aware of the difference between Accounts and Investments. 

The “Second Step” 

In addition to understanding the merits of expected future returns of equities (owning pieces of businesses) vs. cash there is another takeaway that is important: Whether you invest in a taxable brokerage account, Individual Retirement Account, 401K or 403B typically the default investment option is a cash settlement account. If you are investing for a long-term purpose you will want to take a second, very important step. This second step is to “redirect” your current balance, and future contributions, to invest in an investment option that is likely to give you a higher expected return than cash. 

Investing Wisely requires you to own investments that generate future expected returns above the interest rate on cash. While short term needs like saving for a vacation in 12 months or buying a car in 36 months would generally be funded by lower risk/lower return investments like cash or money market funds. Your longer-term investments that are focused on longer term needs/goals such as retirement, health and dental care when you no longer work, college education for a newborn or a retirement property you would aspire to own in 30 years. These longer-term investments are often acquired by owning pieces of businesses (aka equities/stocks) through a low-cost Exchange Traded Fund or Mutual Fund. 

401K and 403B Plans…I’d like a “match” please 

Many companies offer their employees a “benefit” whereby they offer a 401K (For-Profit businesses) or 403B (Non-Profit businesses) retirement account for their employees. To incentivize you to participate by regularly contributing a percentage of your salary, many of these businesses offer to “match” your contribution up to 4 or 5%. Which means that if you sign up to have 5% of your compensation withheld and invested in a 401K plan, your employer may contribute 4 or 5% which would bring your saving up to 9-10%. While you often need to stay employed at the business for 3-5 years to “vest” in your employers’ share of the contribution, this is essentially free money to you.

Note: At least take advantage of the percent necessary to earn your employer’s match. If you start out contributing 4% each month to your 401K, try to increase your contribution rate when you get an increase in your pay. By doing this, you invest in your future self and are less likely to feel a “loss” of day-to-day spending. 

Investment options inside of an employer sponsored 401K or 403B Plan 

If you have an employer sponsored retirement plan as part of your benefits package you will want to make sure that you are taking advantage of the investment options that suit your time horizon and risk tolerance. If you are 25 or 30 years old, the time you have to invest in a long-term investment can be 35-45 years. In this case, you will want to consider the investment options that, over a long period of time, have the highest probability of producing the highest rates of return. While it is impossible to know future returns of investments it may be helpful to see how past returns have performed. 

As mentioned earlier, whether an after-tax brokerage account, an IRA or an employer sponsored 401k/403B account, all of these will have a cash or money market fund as the settlement account that funds go into when you initially buy or sell an investment.

It is VERY important to select investments that best align with your time horizon and risk appetite.  If you open the account and have all your regular savings stay inside of a cash account, it will be extremely unlikely you will be able to generate the investment returns necessary to provide for your long-term goals.  

How much should you save? 

How much you should save out of each paycheck for your long term goals is based on how early you start savings, how much you save, what investment returns will be in the future, when you stop working, what your spending rate will likely be after you stop working and how long you will ultimately live. Despite not knowing the answer to these questions I would encourage you to start as early as you can and add to your investments monthly through an automated employee saving plan, an HSA and/or an IRA via automatic deductions. If you can get up to 15% of your compensation saved for long-term goals, you will be well served. If you can do more, it will give you more flexibility in the future. 

The most important actions you can take are:

1. Start saving early, regardless of the amount, by signing up for an employer sponsored retirement plans or regularly contributing to an IRA/Roth IRA. Take advantage of your employer match, if available,  
2. Select investments that are suitable for the length of time you have before needing the account balance to support your longer-term needs; typically, low cost, diversified equity funds if you have 10 or more years before needing these funds is a decent place to start, 
3. Automate the amount and frequency of your investments (i.e. monthly) by setting up an automatic deduction from your payroll and/or bank account, 
4. Stay the course when the price of your investments drops.  Don’t sell at the bottom.  If anything, add more if you can when markets sell off. While we can’t predict the future, history tells us that over the long term, prices of the broad equity market will come back. Research is very clear that you can’t successfully time when to buy and sell without underperforming the market. When you select investments that have higher future expected returns (i.e. equities) than those with lower expected future returns (i.e. cash) you will experience periodically greater losses (aka higher volatility) in order to realize longer term higher expected returns.

The awesome power of compounding and the importance of the “second step” 

If you have not spent much time looking at the awesome power of compounding returns you should. Start investing early, regardless of how much. Increase the percentage of your earnings invested as your earnings increase. Don’t forget the “second step” once you open an employer sponsored retirement account, HSA, IRA or brokerage account. The “second step” is to redirect from a cash settlement account option to investment options that are likely to provide investment returns that match your time horizon, risk appetite and long-term goals.  

The riskiness of assets needs to be looked at in the context of time and future expected returns 

Investing in a money market fund or cash exposes you to very little or no “volatility” of the principal balance but offers a low expected rate of return (often a negative rate of return when adjusting for the impact of inflation). Therefore, cash may be appropriate for funds you are setting aside for short term needs, but cash saved for long term needs is “high risk.” Why? Because longer-term needs often require higher expected rates of return than the expected returns of the cash/money market can provide.  

Conversely, investing in equities via a low cost, diversified ETF or mutual fund can be a lower risk investment to meet long term goals because the long term expected returns are likely higher than cash. The important behavioral element when investing in a diversified number of equities is that periodically, the price of these investments can decline by 30, 40, 50 percent… in the short term. In order for you to realize the long term higher expected returns from equities you must also stay the course when these investments decline dramatically. 

Your specific situation 

This blog post is meant to be educational and not to be used as specific investment advice. Your specific situation is unique, and any advice should be based on a complete understanding of your situation.