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Financial advice must reflect constantly changing time horizons

The days of simple product time horizons are over. Instead, advisers must manage the combined effects of overlapping, interrelated and dynamic goals.

The concept of a time horizon is a mainstay of suitability. But what does it mean? And where does it fit into the financial planning process?

Including a time horizon in a client’s investment objectives (as required by the Conduct of Business Sourcebook, section 9.2.2) is designed to stop investors from entering positions that would be too risky for them, if they had to get out of them too soon.

As the sourcebook says, "the information regarding the investment objectives of a client must include, where relevant, information on the length of time for which he wishes to hold the investment, his preferences regarding risk taking, his risk profile, and the purposes of the investment".

When ‘investment objectives’ were more closely aligned to product purchases, matching the term of an investment with the term of a singular objective made more sense. That approach, and indeed the regulations that still enshrine it, is a relic of an era the advice profession has left behind. A holistic planning process calls for a more sophisticated interpretation of the rules.

Planning helps investors manage a fluid system of objectives, with shifting priorities, variations in each objective’s importance and costs or deadlines of differing flexibility. School fees happen at a set time or not at all, and the cost is fixed. In comparison, aspirational purchases that one could delay, or substitute a less-expensive alternative for, are more flexible.

In a planning-focused world (especially without forced annuity purchases), how should a time horizon be measured and managed? Is it linked to a product, a portfolio, an individual, or a family? Is it about the time before review, moving managers, withdrawing in part, or in full?

A specific subset of investible assets may have a time horizon, but the notion of a single time horizon is nonsensical when applied (as it often is) to an investor’s real life.

Investment horizons should be determined by when you need cash: how long do you have before your option to choose when to sell expires? When will you need to make withdrawals, and how large might they be? As a needed withdrawal comes closer, you will want to reduce risk to protect it. But by how much? And how quickly?

Each investor has multiple time horizons, because they have multiple withdrawal points and multiple goals. What matters is the weighted average of these horizons, a value that is itself in constant flux.

Managing time horizons

Good risk capacity measurements manage time horizons automatically. Non-negotiable, time-limited goals with no control over cost reduce capacity (and therefore risk), insofar as the deadlines, certainty, and priority of future goals require it. For lower-priority, less-certain, or more distant goals, it is better to stay invested. Divorcing time horizons from the varying importance and flexibility of goals often means giving up future returns to protect assets for uncertain or unimportant withdrawals. This is unnecessary and costly.

If a goal tabled for next year is low priority, it is better to stay invested and withdraw the money only if markets are still high in a year; if not, just postpone the goal.

There is, of course, an emotional side to this too. Our perception of ‘the right time to sell’ is rarely created by a calculator. In times of stress, our emotional judgments can become dangerously distorted. Good investing is not only about determining our investment time horizons, it is also about controlling our emotional horizon - about making sure we have the financial and emotional liquidity to choose when to sell.

Time is an input into a process, not a stationary target. Fixing on a time horizon unhelpfully implies that goals are more static and more independent than they are in reality. Instead, investors need to manage the combined effects of overlapping, interrelated, and dynamic horizons. Good advice is the key to helping them do this.

 

Greg B Davies, PhD - Head of Behavioural Science, Oxford Risk

Greg is a specialist in applied behavioural finance, decision science, impact investing, and financial wellbeing. He started the banking world’s first behavioural finance team at Barclays in 2006, which he led for a decade.

In 2017 he joined Oxford Risk to lead the development of behavioural decision support software to help people make the best possible financial decisions. Greg holds a PhD in Behavioural Decision Theory from Cambridge; has held academic affiliations at UCL, Imperial College, and Oxford; and is author of Behavioral Investment Management. Greg is also Chair of Sound and Music, the UK’s national charity for new music, and the creator of Open Outcry, a ‘reality opera’ premiered in London in 2012, creating live performance from a functioning trading floor.


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