Defining long-term investments
Long-term investing appears virtually slack compared to trading. Your funds are invested and allowed to grow for many years or decades.
In fact, ‘lazy’ is exactly how Berkshire Hathaway Inc CEO Warren Buffett – one of the world’s greatest investors – thinks about successful investing. Buffett wrote, "Our portfolio shows little change: We continue to generate more money when snoring than when active," in his 1996 annual letter to shareholders.
Long-term investing is considerably different from trading in terms of both approach and instruments. Long-term investors concentrate on the performance of the business itself rather than charts or interest rates. Finding out how much money a company can make and determining its value are the goals. Fundamental analysis is the term for this approach. An investor will look to purchase shares of a firm if the share price is less than the investor's appraised value of the company.
You'll see that the business and its future performance are the key points of discussion here. An investor can sit back and let time (and the firm) accomplish the labor-intensive task of compounding returns once they have identified a company, which they want to buy a stake. "The money is made in investments by investing and by owning good firms for long periods of time," Buffett once told CNBC.
An excellent example of long-term investing is Warren Buffett. Through 1996, Berkshire Hathaway owned 8.1% of Coca-Cola Co. and 10.5% of American Express Company. The shares were still owned by Berkshire Hathaway in 2020, more than 20 years later, and the company had even increased its stake in the two businesses to 18.8% and 9.3%, respectively.
Why is the future important? Because a company's earnings may increase and compound at extraordinary rates over time, giving money to patient investors. It does, however, take time. Businesses must make investments in new factories, market their brands, and conduct research on new items that could take years to pay off financially for the business.
Advantages of long-term investments
Better long-term returns
A particular class of investments is referred to as an asset class. They have similar traits and qualities to fixed-income assets (bonds) or equities, sometimes known as stocks, for example. Your age, risk profile, level of capital, investment objectives, and risk tolerance will all affect which asset class is ideal for you. How about the greatest asset types for long-term investors?
Stocks have typically outperformed practically all other asset classes, according to several decades' worth of asset class returns. Between 1928 and 2021, the S&P 500 returned an average of 11.82% yearly. This is a better return than the 5.11% return on 10-year Treasury notes and the 3.33% return on three-month Treasury bills (T-bills).
In the equity markets, emerging markets have some of the largest return potentials, but they also carry the highest level of risk. The average yearly returns for this class have historically been excellent, but short-term swings have hurt their performance. For instance, as of April 29, 2022, the MSCI Emerging Markets Index's 10-year annualized return was 2.89%. 3 Both small and large caps have produced returns that are above average. For instance, the Russell 2000 index, which evaluates the performance of 2,000 small businesses, had a 10-year return of 10.15 percent. As of May 3, 2022, the large-cap Russell 1000 index has returned an average of 13.57% during the previous ten years.
Higher returns have generally been produced by riskier equities classes than by their more conservative counterparts.
Embrace the highs and lows
Investing in stocks is seen as a long-term strategy. This is due in part to the fact that stock value drops of 10% to 20% or more over a shorter period of time are common. For a higher long-term return, investors can choose to ride out some of these highs and lows over several years or even decades.
People who invested in the S&P 500 over a 20-year period have rarely lost money, according to stock market returns going back to the 1920s.
Even taking into account setbacks like the Great Depression, Black Monday, the tech bubble, and the financial crisis, investors would have benefited from investments in the S&P 500 if they had been held for 20 years without interruption.
Even if previous performance does not guarantee future results, it does indicate that, given enough time, long-term investing in stocks typically produces favorable outcomes.
Investors are poor market timers
We're not as collected and logical as we want to think we are, let's face it. In reality, the propensity for emotion is one of the fundamental problems in investment behavior. When the stock market starts to decline, many people make the claim to be long-term investors, but they usually withdraw their money to stop further losses.
When a rebound happens, many investors fail to keep their stock investments. In actuality, they frequently only rejoin after the majority of the advantages have already been made. Buy high, sell low trading usually has a negative impact on investment returns.
In the 20 years that ended on December 31, 2019, the S&P 500 had an average yearly return of just over 6%, according to Dalbar's Quantitative Analysis of Investor Behavior study. The typical investor saw an average annual return of roughly 2.5% throughout the same time period. 7
This occurs for a number of reasons. Here are just a few examples:
Investors worry about being sorry. Especially when markets are down, people frequently don't trust their own judgment and instead opt to believe the hype. People frequently make the mistake of selling their stocks to allay their worry that they will regret sticking to them and lose even more money as a result of the decline in value.
a feeling of pessimism when circumstances alter. During market rallies, optimism rules, but when things go south, the opposite is true. Short-term surprise shocks, such as those relating to the economy, may cause the market to fluctuate. But it's crucial to keep in mind that these setbacks are frequently transient, and things will almost certainly improve.
By trying to time the market too regularly, investors who pay too much attention to the stock market tend to reduce their odds of success. A straightforward buy-and-hold long-term strategy would have produced much greater outcomes.
Lower rate of capital gains tax
Any gains from the selling of capital assets are considered capital gains. Any personal property, such as furniture, as well as investments like stocks, bonds, and real estate, fall under this category.
Any gains are taxed as regular income for an investor who sells security within one calendar year of purchasing it. The term "short-term capital gains" is used to describe these. This tax rate may reach 37%, depending on the individual's adjusted gross income (AGI).
Long-term capital gains are generated when securities are sold after being held for longer than a year. The gains are only subject to a 20% maximum tax rate. Even a 0% long-term capital gains tax rate may be available to investors at lower tax rates.
Lower cost
Money is one of the key advantages of a long-term investment strategy. The longer you retain your shares, the fewer fees you will incur, making holding your stocks in your portfolio longer more cost-effective than frequent buying and selling. How much does all of this cost, though?
You avoid paying taxes, as was covered in the previous section. The Internal Revenue Service must be informed of any gains from stock sales (IRS). As a result, your tax burden goes increases, which means you have to pay out more money. You should keep in mind that short-term financial gains may cost you more than if you held onto your stocks for a longer period of time. 9
Then there are transaction or trading fees. The kind of account you have and the company that manages your portfolio of investments will determine how much you pay. For instance, you might be assessed a commission or markup, the former of which is subtracted from your proceeds when you purchase and sell through a broker, and the latter of which is assessed when a seller directs a sale through their own inventory. When you trade equities, these fees are applied to your account. This implies that each sale you make will decrease the value of your portfolio.
Companies frequently impose recurring costs, such as account maintenance fees, which can also significantly reduce your account balance. Therefore, after transaction fees are taken into account, your fees will increase even further if you are a regular trader with a short-term objective.
Compounding with dividend stocks
Corporate gains are distributed as dividends by successful businesses. These are frequently defensive or blue-chip stocks. Companies with defensive stocks perform well regardless of how the economy is doing or when the stock market declines.
You are able to benefit from these businesses' success because they regularly pay qualified shareholders dividends, often once per quarter. There is a very strong reason why you should reinvest the dividends into the companies that actually pay them, despite the temptation to cash them out.
You already understand how compound interest impacts your investments if you hold any bonds or mutual funds. Any interest that is computed using both the principal balance of your stock portfolio and any prior interest you have earned is known as compound interest. This means that any interest (or dividends) that accumulate in your stock portfolio over time compound, increasing the size of your account over time.
How does compound interest work?
Compound interest is the interest earned on your initial investment or accumulated on a loan coupled with its accrued interest, as was previously described. The amount of interest that accrues when you borrow or deposit money can vary depending on a few variables. These elements include the amount being borrowed or deposited, the compounding period, and the interest rate percentage.
Say you have a $2,000 debt with compound interest and a 12% yearly interest rate that you want to pay off in five years. When you consider the loan amount and payoff period, you might initially believe that this is a simple task to complete. However, compared to a loan with a basic interest rate, a compound interest loan might add significantly more interest to your loan amount rather than simply the first $2,000 you borrowed. Your loan balance would increase by $1,524.68 after 5 years, bringing your total repayment amount to $3,524.68. However, if the loan were for $2,000 and the simple interest rate was 12%, the total amount due in 5 years would be $3,200, which would mean an additional $1,200 on your loan. The difference between the two is that the compound interest rate charges interest not only on the main balance, or the $2,000 loan amount, but also on any prior interest charges on the $2,000. Contrarily, the basic interest rate only generates interest on the $2,000 principal amount of the loan.
Let's imagine that instead of taking out a loan, you choose to put $5,000 in a savings account with compound interest that pays 2% annually and has a yearly compounding period. This implies that your initial $5,000 deposit as well as the interest that has accrued on it will be compounded yearly. Your main balance would increase by $520.40 over the course of five years due to interest, giving you a total of $5,520.40. You would have made $5,525.39 in 5 years if the $5,000 deposit's compounding period was monthly and the interest rate was the same (2%).
Understanding compound interest
How may compound interest be used? You might be able to customize particular compound interest techniques to fit your needs and your financial objectives. However, there are a few considerations to make before beginning your compound interest adventure. Let's recap.
- Money growth over time
Compound interest is a powerful tool for long-term financial growth. Compound interest can be used in a variety of ways, including with savings accounts, money market accounts, certificates of deposit, and stock market investments using mutual funds or dividend-paying equities. You might discover that a particular compounding method is advantageous. The likelihood of your money increasing over time increases with the length of time you hold it or save it.
- Annual percentage yield (APY)
The yearly rate of return on an investment that takes the impact of compound interest into account is known as the annual percentage yield (APY). Does knowing your interest rate matter, then? Interest can be your ally when it comes to investing. Your investment has a better chance of making more money on your principal amount and accumulated interest if the interest rate is higher.
- Compounding periods
As was already mentioned, the frequency of the compounding period can affect how much money grows over time. The amount of money and long-term savings increases with frequency. Making the greatest investment decisions requires research or working with a financial advisor, regardless of whether your attention is on how much money you need for retirement or wealth accumulation.
Why do share prices move long-term?
Share prices fluctuate in the short term for a variety of reasons. However, over the long term, profitable enterprises typically increase in value. Because shares only make up a small portion of a company, investors are more prepared to pay for it if it generates higher profits per share. This is especially true if they think the company can develop over time by reinvesting its profits.
That could account for the nearly 90% correlation between share price change over a ten-year period and increases in sales and profitability. Growing revenue is typically seen by investors as a sign of a successful firm since it allows the company to continue investing in sales and marketing to spur future growth.
Thus, the longer your investment horizon, the more your success will be based on the intrinsic performance of the company rather than the constantly shifting expectations of the market.
Trading vs. Long-term, which has better success?
Long-term holding can be more difficult than it seems. We enjoy purchasing and selling shares because doing so gives us a sense of financial control. However, that doesn't imply that we are any good at it. In fact, according to the research, it would be best if we left it alone!
The investors who moved in and out of the stock market considerably underperformed the market return, according to a study of 66,000 US families with investment accounts at a major discount broker. According to the survey, those that traded the most annually saw returns of 11.4% vs the market's 17.9%. The study's conclusion was unequivocal: "Our main message is that trading is dangerous to your money."
An even more alarming statistic was revealed by a second study on the fate of day traders in Brazil. The study, which was conducted between 2013 and 2015, revealed that an astounding 97% of people who continued day trading for more than 300 days lost money. Only 1.1% of workers in Brazil made more than the minimum wage.
Okay, but how about market timing? You'll be better off if you can just stay away from the major falls, right? The issue is that correctly timing the market is exceedingly challenging. The Dow Jones Industrial Average Index, according to data scientist and COO of Ritholtz Wealth Management LLC Nick Maggiulli, has generated positive returns on about 52% of days since 1915. So, if you're trading in and out of the market, it's almost a coin toss as to whether you'll be profitable.
The decision of when to buy back becomes a new one when selling to avoid a loss. Gains from long-term investing might be severely harmed by sitting on the sidelines. Invesco, a US investment management company, published an analysis that showed that, over an 82-year period, missing just the top 10 performing days resulted in returns that were reduced by around two-thirds.
Our chances of becoming wealthy are significantly improved if we maintain our composure and hold onto our stocks even when the markets are in decline. According to a proverb, investing takes time; timing the market is useless.
Best stocks to hold long-term
When you wish to buy stocks, there are several aspects to think about. Take into account, among other things, your age, risk tolerance, and investing objectives. Knowing all of this can help you determine the kind of stock portfolio you can build to achieve your objectives. Here is a rough outline you can use as a jumping-off point and modify for your own circumstance:
- Decide on index funds. These ETFs move exactly like stocks and follow particular indices, such as the S&P 500 or the Russell 1000. However, these funds offer lower costs than stocks, and unlike stocks, you won't have to pick and choose which firms to invest in. Similar returns to the indices they track are provided by index funds.
- Consider stocks that provide dividends. These stocks can help your portfolio gain value, particularly if dividends are reinvested.
- High-growth companies can strengthen your portfolio. Growth stocks are frequently linked to businesses that can produce a disproportionately high amount of money more quickly than their competitors. Additionally, they are more qualified to present compelling earnings reports. However, keep in mind that this amount of growth carries a larger level of danger, so if you want to take this road, you'll need to be a little savvier than inexperienced investors.
Always seek advice from a financial expert, especially if you're unfamiliar with the world of investments.
FAQ
For how long must you hold a stock for it to be considered long-term?
Like any asset, holding a stock for at least a year is required for it to qualify as a long-term investment. Anything less is considered to be a short-term holding.
What are the disadvantages of long-term investment?
The drawbacks of long-term investments are numerous. They are more speculative than short-term investments, for instance. Compared to short-term investments, they are more volatile. Compared to short-term investments, they have the potential for lesser returns.
How does long-term investment work?
An account that a business intends to hold for at least a year, such as stocks, bonds, real estate, and cash, is a long-term investment. The account can be seen on a company's balance sheet under assets. In general, long-term investors are prepared to accept greater risk in exchange for greater benefits.
Is long-term investing worth it?
When investors attempt to time their holdings, long-term investments nearly always outperform the market. Investor returns are typically hampered by emotional trading. Over the majority of 20-year time periods, the S&P 500 provided investors with positive returns. The ability to weather brief market downturns is regarded as a sign of a successful investor.
Which is an example of a high-risk investment?
Despite the fact that product names and descriptions frequently alter, some examples of high-risk investments include: Cryptoassets (also known as cryptos) Mini-bonds (also termed high-interest return bonds), and land banking (sometimes called high-interest return bonds).