Incorporating Time Horizon in Risk Profiling (Additional Topic)

2.9 Incorporating Time Horizon in Risk Profiling (Additional Topic)

Time horizon is one of the most important, yet sometimes overlooked, aspects of understanding a client’s risk profile. If we think of investing like planning a big trip, the length of time until you reach your “destination” can profoundly shape what you pack in your suitcase. Similarly, the length of time—your time horizon—you have in the market shapes your portfolio composition. Let’s dive into how time horizon and risk profiling go hand in hand.

Why Time Horizon Matters

A person with only one or two years before a large expense or retirement likely cannot withstand extended market downturns. If they need that money soon, they presumably want more certainty and less volatility. On the other hand, someone with decades until they need their money can ride out market storms, seeking greater growth by holding stocks or other volatile assets.

In the Canadian investment context, the Canadian Investment Regulatory Organization (CIRO) emphasizes the importance of ensuring suitable investments across a client’s entire financial lifecycle. Time horizon is a core consideration for any advisor. After all, it links directly to a client’s risk capacity—and ironically enough, it can be more important than a client’s personal comfort with risk.

I still remember my friend—let’s call her Jennifer—who was nearing retirement. She had spent about 30 years working in IT, saved diligently, but had never really updated her portfolio strategy. She was 63 years old and still invested heavily in volatile equities. A 10% market decline just before she planned to retire was a huge wake-up call. She realized she might have overestimated her capacity for risk given her short time horizon. It was at that point that I saw how crucial it is to incorporate time horizon right at the forefront of risk profiling.

Short, Medium, and Long Horizons

Informally, many advisors categorize time horizons as short, medium, or long:

• Short-term: up to 3 years
• Medium-term: around 3 to 10 years
• Long-term: 10 years or more

This rough guideline helps shape your investment approach. If you’re investing a short-term bucket—maybe to cover next year’s tuition or a down payment—there’s little room for a 20% or 30% market decline, so safer, more liquid assets like cash or short-term bonds tend to dominate. For medium-term goals—maybe 5 or 7 years out—you can accommodate some volatility but might still hold a balanced mix of equities and fixed income. For a very long horizon, like 20 or 30 years until retirement, you can tilt more heavily toward equities, real estate, or other higher-risk, higher-reward assets, while still being mindful of the big picture.

Risk Capacity vs. Risk Tolerance

We often talk about a client’s comfort with volatility—called risk tolerance—versus their actual ability to absorb losses without jeopardizing their goals—i.e., risk capacity. Time horizon usually has a more direct impact on a client’s risk capacity: the longer the timeline, the more chance to recover from bear markets. Conversely, a near retiree’s capacity for rejuvenating their portfolio after a downturn is significantly lower. By integrating time horizon into risk profiling, advisors can better shape a portfolio that truly meets a client’s personal ability to handle potential losses.

The Bucket Approach

One popular strategy for incorporating time horizon into risk profiling is the Bucket Approach. This can be particularly reassuring for retirees or anyone drawing down from their investment portfolios. You segment your overall investments into separate “buckets,” each designated for a distinct time horizon:

• Short-Term Bucket (1-3 years): Often containing cash or near-cash investments, such as money market funds or short-term bonds.
• Medium-Term Bucket (3-10 years): Usually a balanced mix of equities, bonds, and possibly some alternative assets, depending on your comfort level.
• Long-Term Bucket (10+ years): Typically includes growth-oriented assets such as equities, real estate, and other assets with potentially higher returns (but greater risk).

Visually, it can look like this:

    graph LR
	    A["Short-Term Bucket <br/> (1-3 years)"] --> B["Medium-Term Bucket <br/> (3-10 years)"]
	    B["Medium-Term Bucket <br/> (3-10 years)"] --> C["Long-Term Bucket <br/> (10+ years)"]

• Short-Term Bucket: minimal volatility tolerance; ensures liquidity and stable value.
• Medium-Term Bucket: moderate volatility tolerance.
• Long-Term Bucket: higher volatility tolerance, with a focus on growth.

Many clients feel relieved by seeing how their “tomorrow” money is protected in lower-risk assets. Knowing that your short-term spending or income needs are covered is a powerful psychological comfort. It’s like making sure you pack your daily outfits in the front pocket of your suitcase. The rest of your gear—bulky winter coats, for instance—might sit safely in the bottom, used only when you actually need them later on in the trip.

The Glide Path Strategy

Another classic approach, used heavily in target-date funds, is the Glide Path Strategy. Picture an airplane descending smoothly toward the runway. Early in the flight (i.e., when you’re far from retirement), you can cruise at a higher altitude (or risk profile) with a bigger allocation to equities. Then, as you approach your “landing spot” (retirement or another major life event), you start reducing that equity exposure and adding more conservative assets.

An example of a simple glide path for retirement investing may look like this:

Over time, the glide path “glides” you into more conservative territory. It is, in effect, building the decline in risk level over time, so you don’t have to make drastic changes at the last minute. Many mutual fund companies (and some exchange-traded funds) automatically manage a glide path for investors, particularly those in target-date funds.

Time Horizon and Withdrawals

Sometimes, it’s not just about a long horizon for overall retirement—there can be multiple time horizons within a single retirement itself. That’s right. Even retirees don’t necessarily cash out all their investments on Day 1 of retirement. Some folks might plan on a 30-year retirement, but they also need money next year for living expenses. This is where the Bucket Approach or an ongoing glide path concept can fold neatly together.

Your short-term bucket effectively covers living expenses in the immediate future, while the longer-term bucket invests in riskier assets to sustain you through the later years. Even after retirement, you often need to keep some portion invested for growth to outpace inflation throughout your golden years.

Putting Theory Into Practice

A short example: Suppose you’re advising two different clients.

• Client A is 35 years old, saving for retirement in 30 years. He’s comfortable with moderate volatility (some nights he tosses and turns when markets drop 10%). But given his time horizon, you might still advise a higher proportion of equities, because he shouldn’t need the bulk of his money until far down the road.

• Client B is 60 years old, aiming to retire in five years, with modest tolerance for risk. She’s behind on her savings, so she wants her portfolio to grow, but also can’t handle too big a drop because she’ll start withdrawing funds soon. Here, you might split her portfolio into a short-term bucket for her earliest needs, a medium-term bucket for around years 5–10, and a longer-term bucket to support her well into retirement.

Remember, the crux is to tailor risk exposure to each time horizon. Even if both clients appear to have similar risk tolerances psychologically, their time horizons drastically shift the shape of their recommended portfolios.

Personal Anecdote

I once met an individual who had a 15-year horizon for retirement but felt extremely anxious about any volatility. Every time the market had even a mild slump—like 5%—she panicked and wanted to sell. Her time horizon was actually pretty long, which meant her risk capacity was decent (plenty of time to ride out downturns), but her risk tolerance was incredibly low. We worked together on a “mini bucket” approach within her portfolio, setting aside about two years of expenses in safer assets. That small tweak gave her the mental comfort to fixate less on the short-term fluctuations. She ended up maintaining a reasonable equity allocation for the rest of her portfolio, which performed well over time.

Common Pitfalls

• Ignoring your need for liquidity. Even if you have a very long horizon, you might need emergency funds.
• Failing to rebalance as your horizon shortens. A 25-year horizon eventually becomes 5 years, meaning your portfolio probably needs an adjustment.
• Overfunding the long-term portion if there are short-term goals. Don’t forget those near-term expenses.
• Underestimating inflation. If you’re overly conservative with a long horizon, you might lose purchasing power in the long run.

Regulatory Guidance and Best Practices in Canada

CIRO guidelines emphasize the need to document and justify the suitability of a client’s portfolio. This includes outlining how time horizon considerations, risk tolerance, risk capacity, and investment objectives all intersect. While MFDA and IIROC are now defunct as separate entities (they amalgamated into CIRO on January 1, 2023), many of the old frameworks insisted on “Know Your Client” (KYC) and “Know Your Product” (KYP) obligations, details of which remain essential. CIRO continues to stress that advisors should match potential investments to the client’s time horizon, as it is a key factor in risk profiling.

The Canadian Investor Protection Fund (CIPF)—previously functioning alongside the MFDA Investor Protection Corporation (IPC)—is now the sole fund offering investor protection in the rare case of a member firm insolvency. For official updates or regulatory resources, check https://www.ciro.ca.

Leveraging Tools and Additional Resources

• Target Date Funds Educational Material from the CFA Institute:
https://www.cfainstitute.org

• Online Calculators and Retirement Planners:
Many open-source financial planning tools (some are free) can help project how different time horizons or geographies might affect your portfolio.

• Asset Allocation Models:
Numerous banks and brokerages offer free asset allocation questionnaires that factor in time horizon. However, use them with care, as they are typically quite generic and do not replace an in-depth conversation with the client.

• Continuous Education
CIRO, along with the CFA Institute, provides new guidelines, case studies, and best practices on integrating time horizons and risk capacity into client portfolios.

Summing It Up

Incorporating time horizon into risk profiling is absolutely crucial. Whether you opt for a Bucket Approach, a Glide Path Strategy, or a custom blend, you always want to align your portfolio’s level of risk with the years you have to invest. It’s about balancing your immediate needs with your long-term wealth-building goals, all while preventing as many sleepless nights as possible.

In finance, it’s all about ensuring your client’s portfolio is matched with the right timeframe. If you keep in mind how soon they’ll need the money—and how tolerant (or intolerant) they are of market dips—you can build a robust plan that integrates seamlessly with their real life. Ultimately, that’s the heart of good advising: bridging the gap between the theoretical power of compounding over time and the real-world constraints and anxieties your clients face.

Test Your Knowledge: Time Horizon and Risk Profiling