The importance of time horizon

Time horizon is amount of time available to accumulate and grow wealth prior to the point when you start consuming (withdrawing) that wealth.  To establish the time horizon, it's helpful to first talk a bit about the different phases of a worker's financial life.

One theory is that a financial life is split into three sections: pre-work, work, and post-work life. While it varies for everyone, for the sake of argument let's call 'pre-work' life birth to 20 years, work life from 20 years to 60 years, and post-work life from 60 years to death. Assuming:

  • The worker can only save money when earning money, and

  • The worker only earns money when he works, then

the maximum time horizon for the long-term investor to save money is the 40 years of his working life; this assumes they begin saving at 20, right at the start of their working life. However, the time horizon for your long-term investments can be considered to be from now (your age at the moment you read this) until you begin your post-work life.  As you age toward the end of your work life, your time horizon continually shrinks toward zero, the value it reaches on the day of your retirement.  

This assumption of post-work life beginning at 60 years old meshes nicely with the federal government's assumptions about a workers life.  Uncle Sam assumes your post-work life will begin sometime between 59.5 and 70.5 years of age, so they structure the tax-advantaged savings accounts (401K and IRA) to mandate you start withdrawing during this window.

Below you’ll find three time-related concepts helpful in understanding the interrelation between time and wealth creation.

  • ‘The Rule of 72’ is a handy estimating tool to determine the time required to double your investment

  • ‘Reversion to the Mean’ shows time’s tendency to moderate return to an expected value

  • ‘The Magic of Compounding’ explains how time can be your most powerful ally in wealth creation

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The rule of 72

A handy estimating tool figuring out the time it takes for an investment to double.  The formula states the following:  to double your money, simply match a interest rate and holding period that multiply together to yield 72. To see some examples, click below...

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Reversion to the Mean

Reversion to the mean is just a way of saying "Over time, things average out".  Take a coin flip.  Do it once, you'll get either a 100% head or a 100% tail. Flip 100 times, it's quite unlikely you'll see 100 heads or 100 tails.  As you flip more and more, the result will "revert" to the mean (or expected average), which for a coin flip is 50/50.  Investment behave in similar ways; the longer you hold the investment, the more flips of the coin happen and the nearer you will approach the expected return. 

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The Magic of Compounding

Albert Einstein called compound interest the "greatest mathematical discovery of all time".  Like the cocktail napkin sketch pictured above shows, compound interest 'compounds' the return on principal by returning 'interest on interest earned'.  This effect is magnified with time, eventually creating an investment that can create it own cash flow.  Click below for more...