In the world of investing there are countless different investment strategies.
Usually, we divide different approaches to long-term investments and short-term investments.
So, what do these terms mean, what are their strengths and weaknesses, and which one should you choose?
Let’s find out!
What is Long-Term Investing?
When you Google the definition of long-term investing, you get about as many different answers as you get search results.
Some say that the long term is over 3 years, some say it’s over 5, and others see the long term as over 10 years.
I think the best way to think about owning a stock is to mirror your ownership to the company itself. If you own a company that’s been around for over 150 years, the definition of long-term ownership also rises.
If you own an aggressive start-up for 5 years, it can be considered a long-term investment, but owning Coca-Cola would require a much longer period of time.
Overall, I’d say being a long-term investor is owning a stock for over 10 years, even decades.
It’s an investment strategy where you keep invested through market downturns as well as upturns, and let the company grow. In most cases, this takes over 10 years to happen.
What is Short-Term Investing?
If the term “long term” is a bit vague as a concept, so is the short term. Average search results vary from 1-3 years, so we can think of short-term investments as investments you hold for a year or so.
Professionally speaking, I consider everything less than 5 years short term, because when you invest in equities, your investment horizon should be over 5 years.
It’s also worth noting that stock investments aren’t usually considered short-term investments in the first place. Usually, when we speak of short-term investments, we speak of account saving, government bonds, or treasury bills.
Short-term stock investing, on the other hand, is an investment strategy where you invest in highly liquid stocks with the intent of making a profit by buying and selling them at a quick pace.
This is more commonly referred to as trading. Traders don’t usually hold anything for more than a year.
As far as investment strategies go, trading is one that requires the most risk tolerance.
For the rest of the article, we define short-term as holding something for less than a year.
Pros of Long-Term Investing
If you’ve read my blog before, you know I’m a long-term investor by heart. I like to think that buying a stock is the same as owning a company.
I wouldn’t sell my own company because of one or two bad quarters.
The way I see it, long-term investments have a lot of benefits.
Lower Risk Level
The longer you hold a great stock, the lower your risk level becomes.
Robert G. Hagstrom calculated in his book, The Warren Buffett Way, that between 1970 and 2012 the average number of stocks in the S&P 500 index that doubled in any one year was only 1.8%.
When increased to five-year blocks, the average that doubled was 29.9 percent. So, during a five-year period, 150 of the 500 companies doubled.
This would mean that on average, the longer periods you hold, the higher your probability of beating the market is.
For the record, doubling every five years equals 14.9% annual returns, so not too shabby!
To put it in another way, the shorter your time horizon is, the more random the stock price movements are, and thus the riskier your investments become.
Compounding Returns
The greatest returns in investing (and in life) are achieved through compounding.
I’ve written about compounding returns before, so if you don’t believe in the awesome power of compounding, you should definitely read the article!
Now, the thing is that compounding requires time, usually several years and more, which is why you’re most likely to achieve compounding in the long term. I’m not saying you can’t achieve compounding and build wealth with trading also, but it’s a lot more difficult than with long-term investing.
The reason why a longer time horizon works well with compounding is the fact that it takes time for companies to grow and accumulate profits.
Fewer Transaction Fees
Because long-term investing requires fewer trades, you also pay fewer transaction fees. Depending on your investment strategy, the fees you pay can play a major role.
The thing is that the only certain way to get returns is to minimize your fees. If you pay a fee of 1%, you need to gain an additional return of 1% to break even.
So, the more trades you make the more you pay.
Also, if you are a day trader, you will most likely need to purchase software (and hardware) that adds to your fees.
Simplicity
When you make long-term investments in index funds, for example, your investment process is about as simple as it gets.
The easiest way is to find a broadly diversified index fund or a mutual fund and start investing monthly. Of course, there are still some mistakes you can make, but overall, it’s the most convenient way of investing.
Stock-picking, on the other hand, might be a bit more complicated, but the principles behind it are not.
All you need to do is find a growing and profitable company with a strong balance sheet and a reasonable price.
Also, one of the major benefits of being a long-term investor is the fact that you don’t necessarily need fancy software to succeed.
All the information long-term investors need is provided by the company itself.
Because in the long term we are interested in the fundamentals, the most valuable information usually comes from quarterly and annual reports.
Cons of Long-Term Investing
Takes Time (surprise, surprise)
Whether you invest in individual stocks or in mutual funds, the beginning is always the hardest part.
Compounding doesn’t happen overnight. Long-
For the first years, it feels like there isn’t much going on. Even if you’d make a very decent return of 15% per year, in the beginning, it doesn’t feel like you’re on your way to wealth.
When you invest in the long term, you have to have immense amounts of patience and trust in yourself and your portfolio.
Can be Tough on Your Mind
The idea of long-term investing is to stay invested, which means that your capital is tied into your long-term investments. This leads to the fact that you will miss out on quite a few short-term opportunities.
As a long-term investor, you have to learn how to live with the fear of missing out. This is especially important during strong bull markets when it seems that people are getting 100% returns on weekly basis, and everyone is making a fortune.
Of course, it’s wise to remember that there are no guarantees that you would’ve picked up on the great opportunities as a short-term investor either.
You also have to have strong trust in your own decisions. During long bear markets, you start to second-guess your investments and wonder whether the stock price will ever rise again.
All this can take a toll on your mind, especially if you’re a beginner going through your first market downturn.
The Risk of Making Bad Decisions
The idea of long-term investing is to own great companies through different market conditions and let the companies work for you.
The difficult part is not only withstanding different market conditions but also making the right investment decisions.
When your company is down 60% and you’ve made a bad investment decision, it might never recover. A short-term investor probably would’ve sold the same stock a long time ago.
The thing is that as a long-term investor, your bad choices are extremely expensive. Not only will you lose the money you invested, but you also lose the money you could’ve made investing elsewhere.
In other words, the opportunity costs of making bad decisions are high.
Pros of Short-Term Investing
Huge Return Potential
Making a lot of trades can offer you immense returns if you succeed.
While compounding takes a long time for a long-term investor, as a short-term investor you can achieve it considerably quicker.
A short-term investor can achieve in a week what takes long-term investors years to achieve.
The thing is, that achieving compounding as a short-term investor obviously requires that you make a lot of successful trades, which can be harder than it first seems.
Flexibility
Because short-term investments don’t require tying your capital for a long time, you can have a more flexible approach toward your investments.
When there’s room to make moves, there are a lot more opportunities to benefit from market movements and adjust your portfolio accordingly.
There’s also the benefit of limiting your losses more easily. A short-term investor can, for example, decide that a certain stock can only decline 5 percent before it’s sold by setting a stop-loss order to a certain price.
Obviously, minimizing losses is an essential part of any successful investment strategy, and it’s a lot easier for a short-term investor.
More Opportunities for Success
Since short-term investors don’t have to care about fundamentals that much (or at all), the investment opportunities are pretty much unlimited.
For a long-term investor, the fundamentals do matter, which means that opportunities are also limited
For example, a company that’s highly volatile and going through a difficult time is usually a bad choice for a long-term investor but can be an amazing opportunity for a short-term investor.
It’s worth remembering that a company can be both a good and a bad investment, depending on your investment strategy.
Because short-term investors make a lot of trades, they also have a lot of chances for success. Unfortunately, it comes with a price.
Cons of Short-Term Investing
Trading is Difficult
The number one reason why I haven’t dabbled into trading is the fact that it’s insanely difficult.
While the underlying principle of buying low and selling high is quite understandable, the reality of it is completely different.
The probability of success is extremely low. The fact is that most traders will not succeed.
While some technical analysts might disagree, I believe that short-term stock price movements are mostly random.
There can be some advantages to be had from technical analysis and all that, but I think the odds are still not in your favor. When you operate on a shorter time frame, chance takes a bigger role in your investment portfolio.
Higher Risk Level
Because making constant successful trades is so difficult, it also increases your risk level immensely.
A short-term investment strategy requires a high tolerance for risk, which means that it’s not suitable for most people.
While we might think that we have nerves of steel and can withstand any amount of risk, it’s usually not so.
When the risk level gets too high, we usually start to make poor decisions, which incidentally don’t fit well with a strategy that requires making great decisions constantly.
So, there is a potential for huge returns, there’s also a real chance for extreme losses
Requires Time and Effort
While a long-term investor can buy a stock and let the company work for him, a short-term investor has to constantly work for himself.
One reason why I think long-term investing is so effective is the fact that you only have to do the hard work once, and that is analyzing the companies or funds you invest in. After your investment, the companies continue to work and accumulate profits for you.
Making short-term trades, on the other hand, requires continuous effort, which means it takes quite a lot of your time.
Successful traders also usually use a fair amount of different software, which can take quite a bit of time to learn.
Which One Should You Choose?
The investing strategy you should choose depends on, among other factors, your risk tolerance, investing goals, and time horizon.
One is not necessarily better than the other, since both short-term and long-term investing strategies have their strengths.
Then again, why not do both? There are no rules when it comes to investment strategies.
The core of your portfolio can be allocated to long-term investments and a smaller part to short-term investments. This way you can choose investments from both categories.
If you’re not sure what to do, it may be wise to start with a monthly-based investing plan and invest in passive index funds or mutual funds. After that, you can experiment with small amounts of money and try out different investment strategies if you wish.
