When making investment decisions it is crucial to have an understanding of one’s risk tolerances and return expectations. The relationship between these is well known to many but in short, the greater the risk or likelihood of loss, the greater the expected return. However, there are a few nuances within this relationship and the outcome is not a binary one that suggests higher risk equals higher return. 

One such nuance is the investment term or the length of time for which the investor is willing to remain invested. 

Upon committing to an investment, it is imperative to have a clear understanding of one’s investment horizon. Time horizon, simply put, is the period an investor has to make their money work. A general rule of thumb is normally the longer the time horizon, the greater the potential that the investor will achieve their investment objectives.  

Let’s have a look at one of the most famous investment opportunities of this generation: Tesla Motors

Investors earned 11,931.82% in 10 years!

That’s what investors who purchased Tesla one year after it first was listed on a public exchange earned. The stock was listed on June 29th 2010 and earned and impressive 66.42% after one year. Investors who took a short-term view would have lost out on an additional 11,931.82% or $3,375.51 of upside for every 1 share purchased.

Breaking the first year up a bit, early investors who got in on June 29 2010 would have purchased at a minimum price of $19. Seven days later they were sitting on a 21.16% loss as the share price dropped to $14.98. One year later the stock was up over 60%

The Tesla example has several potential outcomes, first, for an investor or speculator who decided to purchase the stock, either because it was an IPO or they heard about the hype around this new electronic car company and its enigmatic CEO. They may have gotten scared off after 7 days siting on over 20% in losses and decided to cut their losses and sell.

Then for those who purchased on July 7th or at IPO who were up over 68% in one year by June 29th 2011, three times more than the overall market. For almost any investor this would have been much more than their initial projections and expectations, hence it would seem perfectly rational to sell and “take profits”.  

For investors who had a long-term horizon and maintained their investment they would have benefited from the 11,000% plus surge the stock went on to achieve after its first year on as a listed company. 

While Tesla was a “once in a lifetime” opportunity (or maybe lightning could strike twice in our lifetimes!), investors who purchased the stock with a clear expectation of their investment horizon and return expectations would have either remained invested after reviewing their position during the investment term or exited upon the achievement of their objectives without many regrets of the opportunity missed.

Briefly going back to the Tesla example, loss aversion may have influenced some to sell after one year to lock in the 66.42% earned.  Investors with limited self-control, mental accounting and an illusion of control may continuously seek out short term investments or routinely terminate investments as a means to ensure they have continued access to not only to their capital but the returns as well.  

Emphasizing on the short term can be detrimental to ones’ finances and investments and often results in an unfavourable outcome for the investor. As the Tesla example shows, the opportunity missed turned out to be in the thousands of percent. But even if we take a more ‘average’ example, the cost works out to be the difference in the ability to afford retirement or buying a home or paying for your child’s education.

Taking a short-term view toward investing and managing one fancies has several shortcomings:

Consider the following scenarios from one institution where both investments are eventually left for three years:

1. Invest for one year and earn 3%. An investment of $1,000,000 would earn $30,000 per year and $1,092,727 with annual compounding
2. Invest for three years and earn 3.5%. An investment of $1,000,000 would earn $35,000 per year or $1,105,000 with simple interest. 

Why would there be different rates from the same institution? There is an administrative cost to renew the investment annually, there is also a cost to make the $1,000,000 available to the investor yearly. These costs are reflected in the lower rate of return offered for the one-year facility vs the three years. Investors with illusion of control and mental accounting biases may prefer the 1-year investment vs the three-year. The investor who chooses the short-term investment is also taking on reinvestment risk, that they may not be able to either renew the investment or secure favourable rates upon renewal. Therefore, unless the investor’s time horizon is one year and they have expenses that become due, it would make sense to seek out the longer dated investment.

Another potential drawback of taking a short-term view on investments is when investors attempt to time the market and end up making losses or losing out on capital gains. The following charts are the 5- year and 6 months charts for Tesla Motors.

It is clear from the chart that the long-term investor would have benefited much more from the prolonged periods of price appreciation whereas the short-term view would have remained fairly flat.