FAQ  #3. Why is time frame so important in dealing with our financial future? What does it mean, anyway?

Planning can, and should, be done with using different time horizons, that is by peeking into variously distant stages of the future. This is what is meant by using different time frames in planning. Time frame plays an important role in the evaluation of investment performance as well.

Why is time frame so important? It is because what can be a best arrangement for a short range evaluation might be far from the best alternative if the evaluation is done according to the long term outcomes. You can discern easily what I’m talking about if you have heard the old tale about the goose laying golden eggs. Staying away from animal husbandry and fairy tales, we can instead refer to the dubious advantage, for example, of cost saving by buying term insurance, or the importance of contributing to saving plans early. What might seem to be the best today or on the short run (buy the cheapest protection, spend all the money today instead of saving) can easily turn out to be a poor option on the long run. On the other hand, some decision may be undoubtedly the best on the long run, in principle, but still not a good one overall, because it would involve short term preconditions you are unable or simply unwilling to accept or provide.

By neglecting temporal aspects, it’s easy to under- or overestimate, for example in retirement, the optimal level of affordable future consumption, even if we have a reliable tally of current assets and income and a good estimate of their future values. Inflation has a significant long term impact on everything, and it is not easy to grasp it intuitively.

Examining various time frames is very important when we analyze and compare the risk/return characteristics of various kinds of investments, and relate these to our planning horizons. When evaluating existing or potential investment positions, taking a longer time horizon makes a riskier asset more attractive than a less riskier one, and vice versa. Looking at longer periods saves us from confronting the reality of what is usually happening on a short time basis, thus provides an antidote against the well documented psychological tendency of loss aversion, that is attributing much higher importance to losses than gains.

Considering various historic returns by holding times (rolling period returns) is very instructive in this regard. The charts below each show the performance of the same market (TSX total return index) during the same long time period (1934 to 2006). The only difference is in how we look at the same history. We start with highly fluctuating (sometimes elating and at other times nerve braking) monthly returns:

There were a lot of months when investors in the TSX index felt disappointed and nervous.
Then, we expand our time horizon, first to 1 year, then to 3, 10 and finally 20 years. How many times did somebody feel desperate over these results? The less frequently looked at the more encouraging the returns seem to be.

There is an interesting reinforcement feedback loop at work here around the time frame we apply: The more frequently we look at performance (short term results), there will necessarily be more times when we see losses, making us more nervous, … easily leading to new transactions, which is usually bad for performance, … and then the cycle is back at Step 1, seeing more frequent upsetting results. Unfortunately, using too short time horizons is typical not only of many investors. Incentives in the financial industry, and perhaps our whole chronically stressful culture of accelerating time and instant gratification, push money managers and advisors in this direction as well, even though it clearly harms performance on the long run. The most important lesson from all this is perhaps that you have to look at both the long and the short term, while keeping in mind the primacy of the long one.

One can argue for Socially Responsible Investing as well from a time horizon point of view too. SRI naturally focuses on the long run, on sustainability, instead of quick bucks. Minding the business practices that contribute to a sustainable future helps focusing on ‘where the pack will be’, instead of ‘where it is now’, … the secret of success as revealed by Wayne Gretzky.

Experts and calculations can help you in envisioning various future options and scenarios, and getting numeric estimates for each in various time frames, but reconciling the lessons from using these various time frames and making decisions based on that is the conclusive part of planning nobody can really do for you, instead of you.

Please see more about time frames in FAQ #5 and FAQ #6, and learn about the ‘time value of money’ concept by playing with financial calculators.