There is nothing more important in deciding between mutual funds or even if one should be investing in a mutual fund at all than the time frame that one wishes to invest in. Each fund and particular type of fund operates in a given time frame, and these time frames tend to operate in the medium to long term.
In order to properly benefit from investing in a mutual fund, potential investors need to make sure that their objectives and the fund’s objectives are properly aligned, otherwise the fund may successfully achieve its objectives while an investor who is looking for something else may not be successful.
For example, if a fund uses a long term buy and hold strategy with a basket of stocks, and an investor buys into it with the intention of only holding the fund for a much shorter duration , a year or two for instance, these strategies are not going to be in harmony with each other. Whether this fund will perform well during the investor’s time frame will be more of an accident than anything, as the fund is not set up or designed to perform during that time frame, but is set up to instead deliver over a longer one.
When Longer Term Strategies Just Aren’t Appropriate
Buy and hold strategies with stocks assume that since stocks have accumulated in value over the long term, once the normal ups and downs of the business cycle are allowed to play out, buying and holding something over many years is likely to produce good returns on investment without taking on as much risk as shorter term strategies with stocks may involve.
During shorter term holdings though, if the intention is to sell during this time, not only may you be in the midst of a downward business cycle or market pullback, but your investments are designed to ignore these shorter term pullbacks, as a matter of strategy.
If someone is looking to retire in 5 years for instance, and they put their money in a mutual fund consisting of stocks, by the time they retire they may end up suffering significant investment losses. The value of the fund may decline by a third for instance over this time and the fund’s managers aren’t going to worry about this, as they are in for the long haul and would not usually want to sell under these conditions.
Smart investors who are focused on the long term will usually buy more on pullbacks, as stocks become even more of a bargain at these times. Mutual funds will often add to their positions during down cycles as well.
However, you’re looking to cash this in as you need the money, so you need to sell now, not wait another 10 years or more where you may reasonably expect that things will play out enough such that you may expect a nice annualized return.
You’re selling at the absolute worst time though for this strategy and the reason why you are subject to these risks is that you chose the wrong investment vehicle.
Fitting The Strategy with the Time Frame
Perhaps you have a friend in the same boat but he or she chose a more appropriate strategy for the time frame. Perhaps your friend invested in bonds which, unlike stocks, can be bought and held during this 5 year time frame with a good expectation of a positive return.
Maybe another friend put the money in savings because they just didn’t want to expose themselves to any real risk. Even the risk of investing in bonds was seen to be too high by the friend over what could be earned on a certificate of deposit for instance.
Another person that you know who is also looking to retire decided that they wanted to seek the sort of returns that investing in stocks provide, and even wanted to shoot for even larger returns. They decided to manage their stock portfolio from a shorter term perspective than your mutual fund took, and when things started to turn sour, they exited their positions, at the point where it became wiser to do so than to stay in given their desired time frame.
This friend did better than you did even without knowing anything else, because he or she was out of the stock market during a lot of the decline prior to the 5 years elapsing, while you stayed in because you were in something that does not account for your shorter time frame.
This can also be accomplished by simply looking to move out of a long term focused fund, and even move back in if that becomes appropriate. This would be a perfectly fine strategy provided one has the skill to manage this, to make the right entry and exit decisions.
People who invest in mutual funds generally do not have the proper skills to do this though, even though it is really not difficult at all to acquire the basic skills needed to manage the bigger ups and downs that occur.
Many people mess these things up though and the advice that is so often given to individual investors to stay the course and not look to time the market is very often good advice. It’s not that it’s that hard to time the market successfully, if one knows what one is doing, but so many people do not and in particular will let their emotions rule their trading.
This all makes it even more important to make sure that you are in investments whose goals align with yours, not perfectly, but at least in a general sense, and why people do need to be careful to make sure they can and will stay the course if their investments are centered around long-term capital appreciation.
Medium Term Time Frames
The easiest path to follow with mutual funds is the long term, because all you do is get into a long term focused portfolio and stay the course. This cannot remain the case indefinitely though, as there will almost always be a time where you are planning on cashing in at least part of your mutual fund investment to be either allocated to another type of investment or to be used for some other purpose.
Since your mutual fund investment will be winding down at some point, where the investment horizon will move from long term to medium term and ultimately to short term, these changing circumstances must be accounted for.
It is not just when you open a mutual fund where you need to assess your investment horizon, as this needs to be done on an ongoing basis, whenever the time horizon changes enough to potentially affect your portfolio.
This often is not done properly and we will see people who are cashing in endure some downswings in the market that they probably should have chosen not to be exposed do, at least so much. While they may have held their investments for many years and may have done very well with them overall, this is no reason to not account for changing time horizons.
The first transition is moving from a long term time frame to a medium term one. There is no set time that is used here but this is generally where investors want to move most of their investments out of stocks and into income type investments, such as bonds.
Income type investments don’t just deliver income, the main reason to look to this class of investments as you move into the medium term is that they fluctuate less and therefore are less risky. Due to this lower rate of fluctuation compared to growth funds, income funds also recover more quickly from downturns in value.
This is actually the biggest reason why income funds are more suitable for the medium term, because the time where they may be relied upon in most cases to be profitable. So what we can do is look at the return for a given medium term investment over a given period such as 5 years, and when we see that it usually yields a good return over this period, we can be fairly confident that it is appropriate for that time frame.
Short Term Time Horizons
As we get even closer to the time where the money will be needed, which also includes looking to open up mutual funds during a short time frame, the good options become more limited. This is the time frame where the savings component tends to come into play more, and typically we would want to prefer a mutual fund focused more on savings for this time horizon, if we even choose a mutual fund.
It’s not that other types of asset classes aren’t ever preferable in the short run, and in fact you can trade these in the shortest of time frames with the right skill, but when you’re letting the mutual funds managers manage things, well they simply aren’t going to trade a fund that way to have the objective of shooting for short term returns as their primary objective.
If someone is looking to trade growth or income assets over the short term, exchange traded funds or ETFs are the better choice overall generally. These are similar in many ways to mutual funds, although ETFs are traded like stocks on exchanges, and can also be traded on an intraday basis as well.
When looking to decide whether a short term approach is best, it’s important to consider when a particular portion of your holdings will be sold. If only a part of it will be needed, and the rest may be kept for the medium term, then it is wise to treat the portion that is to be held in the medium term with a medium term strategy, and the short term funds with a short term strategy.
This is how it can make sense for people even in their advanced years to maintain an income approach to their investments if they are looking to live off the income of them and not really draw down the principal of the investment very much. It’s the principal that matters here.
Different time frames with mutual funds call for different approaches, and it’s important to always account for the time frame that you are in when deciding not only what type of mutual funds to select, but which ones to stay in over time as well.