Time horizon is likely the most misunderstood concept in the investment lexicon, yet an investor’s perceptions about it are among the biggest drivers of much investment policy.

Properly framing the time horizon is an essential first step toward constructing a portfolio that reflects an investor’s goals in a realistic way and can head off behavioral and emotional mistakes that are often responsible for poor long-term performance.

Time horizon is essentially the period at the end of which a sum of money will be needed. The ending points are usually marked by a terminal event when the money will be needed for something. There are four common terminal events: a large purchase, such as a home; college tuition due dates; the beginning of retirement; and death. These events form the boundaries of a time horizon.

Often, more than one time horizon is at play and a blend is appropriate. Occasionally, there really is no time horizon, and money processes can go on in perpetuity.

College is an example of a terminal event where, for the most part, money will absolutely be needed at a specific time. As the freshman year approaches, the portfolio’s risk levels must be reduced because the assets almost certainly will be liquidated for college expenses. The same is true for large purchases or short-term needs.

Other time horizon categories —for example, retirement —are much trickier. Many believe that as retirement approaches, portfolios need to become more conservative. However, because all of the money will not be needed at one time, the terminal event approach is inappropriate. A change in portfolio allocations may not be necessary as retirement approaches. Most people will incrementally take money from their portfolio after they retire, usually over decades.

In retirement, unlike in college funding, the idea is to not to exhaust the money, but rather to make it last (at least) until death, while producing some cash flow to supplement other retirement income. Of course, because the date of death is unknowable, we have a continuum with no scheduled terminable event but instead an ongoing need for cash.

Supplemental retirement cash flow means incremental, not lump sum, withdrawals. These usually occur quarterly and at an annual rate of 5 percent or less. Assuming a balanced portfolio, which should have 20 to 40 percent in cash, bonds and other potentially stable investments, a 5 percent withdrawal can be supported for years through liquidations of stable portfolio components with some support from dividends and interest. Although there is no guarantee that any income strategy can produce the desired income in all market environments, that approach has historically provided enough latitude for the riskier parts of the portfolio to recover from declines.

If the investor’s goal is to provide a legacy, then the objective is based not on the investor’s situation but on that of the investor’s heirs, usually children and grandchildren. Thus, a portfolio would reflect a multigenerational —and therefore a multidecade —horizon. If properly organized, the assets could stay invested indefinitely.

Because the money in these instances has, by definition, a long-term time horizon, it can be more aggressively invested. More aggressive portfolios have had higher long-term returns, albeit with more volatility and risk.

But what about death —is that a terminal event? Although death is a terminal event for the decedent, it is not for the portfolio. Death does not necessarily mandate a liquidation of assets and therefore should not be a time horizon marker for most investors.

When older investors say, “At my age, I need to be conservative because I won’t have time to make up the losses,” our reply is that as long as you do not need all of the money at any given point, including at death, a well-diversified portfolio should be able to meet normal cash flow demands for the duration of a typical retirement.

Time horizon is indeed a key variable in financial planning. A proper understanding and application of the concept can help investors avoid the “one-size-fits-all” mistake when thinking about their time horizon.

As seen in the 9/30/2011 issue of Washington Business Journal