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Time Horizon Can Determine Risk Tolerance

Wells Fargo Investment Institute - April 15, 2020

by Global Asset Allocation Strategy Team

Key takeaways

  • Fears surrounding the coronavirus pandemic and its impact on economic activity and corporate earnings have taken center stage. Investors may be reevaluating their tolerance for risk as volatility surges given the market's recent fall into bear market territory.
  • Investors’ tolerance for risk can depend greatly on investment goals and time horizon. Goals can range from generating income to growing assets. Time horizons can be short, intermediate, or long.

What it may mean for investors

  • Determining investment goals, risk tolerance, and time horizon are important steps that can help lead to long-term financial success. We recommend reviewing a portfolio’s asset allocation with an investment professional on a regular basis to make sure it continues to align with investment goals, risk tolerance, and time horizon.

Fears surrounding the coronavirus pandemic and its impact on economic activity and corporate earnings have taken center stage. Investors may be reevaluating their tolerance for risk as volatility surges given the market's recent fall into bear market territory. The S&P 500 Index selloff triggered by the pandemic caught some investors by surprise. Meanwhile, equity market volatility (measured by the CBOE Volatility Index®, or VIX®)1 has spiked to historic levels in recent weeks— exceeding levels that we observed during the 2008 financial crisis. Investors accustomed to low levels of volatility throughout the protracted bull market now likely are feeling uneasy about the resurgence of volatility.  

We believe investors who are concerned about the market's ups and downs should consider their time horizon—the amount of time investors have until they will need to sell assets in their portfolio to fund an investment goal. 

Time horizon can influence an investor’s willingness to take on risk—it is one component that can help to align investment goals with risk tolerance. Financial markets can be extremely volatile on a short-term basis, and some investors may be unable to tolerate sizable drawdowns in their portfolios—even if those moves are only on paper. Investors with shorter time horizons may be more likely to select conservative allocations, while investors with longer time horizons (and ample liquidity—as employment loss can be a concern in today’s pandemic scenario) often are willing to take on more risk and may choose a moderate or aggressive allocation. As the left side of Chart 1 shows, over shorter time horizons, higher-risk assets, such as equities, can experience wide price swings. Diversified asset allocations generally have seen less volatility. While high-quality fixed income assets historically have had some of the lowest volatility, they may not provide enough return to meet long-term goals. 

Chart 1. Hypothetical annualized rolling 1-year and 10-year returns (January 1990-March 2020)

Chart 1. Hypothetical annualized rolling 1-year and 10-year returns (January 1990-March 2020)

Sources: Morningstar Direct, Wells Fargo Investment Institute; March 31, 2020. MGI 3AG = Wells Fargo Investment Institute Moderate Growth & Income Three Asset Group Portfolio. For illustrative purposes only. The MGI 3AG Portfolio is hypothetical. Index returns are not fund returns and are not forecasts of expected gains or losses a portfolio may achieve. Index returns reflect general market results, assume the reinvestment of dividends and other distributions, and do not reflect deduction for fees, expenses or taxes applicable to an actual investment. An index is unmanaged and not available for direct investment. Hypothetical and past performance are no guarantee of future results. Please see the end of this report for the composition of the MGI 3AG Portfolio, the definitions of the indices and the risks associated with the representative asset classes. Note: Over a 10-year rolling period, neither the MGI 3AG and Bloomberg Barclays U.S. Aggregate Bond Index showed a loss. In fact their minimum rolling returns were positive, 3.2% and 3.5%, respectively, on an annualized basis.

Looking out to a 10-year horizon (right side of Chart 1), historically the potential for loss has diminished—as market cycles evolved and short-term losses eventually turned into long-term gains. There is greater potential reward in equities, but the risk is higher. There is lower potential reward in fixed income, but the risk typically is lower. A diversified asset allocation (such as the one shown in Chart 1) historically has captured much of the upside in equities without generating a loss over any 10-year rolling period since 1990. Over the same period, average annualized returns for the hypothetical Moderate Growth & Income 3AG Portfolio (Chart 1) have kept up with the S&P 500 Index and have outpaced the Bloomberg Barclays U.S. Aggregate Bond Index. 

Determining investment goals, risk tolerance, and time horizon are important steps that can help lead to long-term financial success. If an investor’s time horizon is short, and recent equity market volatility has been unnerving, then a conservative asset allocation may be the best approach. If an investor’s time horizon is long (and the investor has ample liquidity), the willingness to take on risk may be greater, and the portfolio’s asset allocation can lean more toward growth assets like equities. For investors whose time horizon and risk tolerance are somewhere in between (like many investors), a reasonable balance between growth assets and income-producing assets may be appropriate. We recommend reviewing a portfolio’s asset allocation with an investment professional on a regular basis, regardless of market conditions, to make sure it continues to align with investment goals, risk tolerance, and time horizon.

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1The VIX shows the market's expectation of 30-day volatility. It is constructed using the implied volatilities of a wide range of S&P 500 index options.