What is Long-Term Investing
At the heart of long-term investment strategies is the idea that you hold the companies you invest in for a long time to let the company grow and the profits run.
But what exactly is a long time?
Some say that the long term is over 3 years, some say it’s over 10, and others think it’s even decades or a lifetime.
Financial advisors and other professionals usually view long-term investments as investments that are held for more than one year. Although it’s a useful definition, I’d say the reality is more complicated than that.
I think the best way to think about owning a stock is to mirror your ownership to the company itself.
If the company is doing great for 100 years like Coca-Cola, for example, then the long term would indeed be a lifetime.
Then again, if there’s a change in the company’s fundamentals and the future of the business is seriously in jeopardy, it might be time to back out. This can happen after two years or after 50 years.
There’s really no simple answer to this, but you can think of long-term investing as an activity where you own the company long enough to either see it grow or start to shrink.
Whichever happens, it’s due to fundamentals, not the stock price, and that’s what’s at the heart of long-term investing.
The Main Benefits of Long-Term Investing
Allows Compounding Returns
The biggest benefit of long-term investing is that it allows your profits to compound. What this means is that over time, your profits start to generate additional profits, and your wealth will accumulate exponentially over time.
You can’t achieve this in the short term. Looking back at my own mistakes, I practically made it impossible for myself to achieve any compounding returns because I sold the stocks before they ever had the chance to compound.
If you want a stock to go up five or tenfold, you need to give it time. Compounding demands a long time. The longer your time horizon, the greater the effect of compounding.
When we think about it, the thing that drives stock prices up in the long term is that the businesses you invested in are growing profitably.
When a company makes a great profit, it becomes more valuable, and sooner or later, when investors pick up on it, the stock price will reflect the success and go up.
In fact, one thing that all the greatest investors in the world have in common is that they’ve stayed in the market for a long, long time.
If you think about Warren Buffett, for example, his net worth was “only” around $3.8 billion when he was 59 years old. That’s after 40 years of investing, give or take a year or two.
Now, 30 years later at an age of 92, his net worth is about 114 billion dollars.
That’s an increase of $110 billion in just 30 years, compared to that of $3.8 billion in 40 years.
So, in other words, it took 40 years for Buffett to earn about 3% of his total wealth, but only 30 years to accumulate the rest 97%.
If you ever doubt the massive effect a long time frame and compounding returns have, remember this example!
Lower Risk Level
Imagine a situation where you were forced to have a maximum holding period of five months for your stocks.
For most companies, nothing fundamentally changes in such a short time, but you have to sell them anyway and replace them with new companies.
After five months, you would have to do this again with new stocks.
As you can see, it makes absolutely no sense whatsoever. Virtually nothing has changed in the companies except the stock price. Since we have no way to figure out what the stock price will be in the next five months, the risk level is essentially through the roof.
You’re as likely to sell at a loss as you are to make a profit.
Now, you might object and tell me that no one really acts like that in the real world. Well, the statistics say that people behave exactly like this.
The average holding period for stocks nowadays is about five months.
Five months.
Even if you’d be the best stock-picker in the world, five months is nowhere near enough time to prove you right.
Because the short-term movements are completely random, the longer you hold stocks, the lower your risk level becomes.
In fact, 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 your holding period, the higher your probability of beating the market average is. This is because, in the long term, the stock market tends to go up.
For the record, doubling every five years equals 14.9% annual returns, so it’s not too shabby!
To put it in another way, the shorter your time horizon is, the more random the stock price movements are due to short-term fluctuations, and thus the riskier your investments become.
When you hold a stock for a long time, you essentially allow the business to grow and succeed, which is reflected in the stock price in the long run.
Fewer Transaction Fees and Overall Expenses
Because long-term investing requires fewer trades, you also pay fewer transaction fees.
Depending on your investment strategy and service provider, the fees you pay can play a major role in your performance when you’re trading shares back and forth.
Not only do you pay extra fees, but you will also have to pay capital gains taxes for the profit you might make. If there is something that will cripple investor returns, it’s fees and taxes.
With long-term investments, there are more tax benefits because you don’t constantly sell your winning stocks.
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 just break even.
So, the more trades you make the more you pay, and the less profit you’ll make.
Also, if you are a day trader, you will most likely need to expensive purchase software (and hardware) that adds to your expenses.
I’d also point out that statistically speaking, less than 10% of day traders actually manage to turn a profit. Some say only about 2-4% manage to make a living out of it, and 90% lose money in the long term.
While the numbers can never be accurate, they do make the point clear: day trading is expensive and extremely difficult.
Simplicity
One of the main benefits of long-term investing is that it’s one of the simplest forms of investing with a high success rate.
The easiest way to begin investing is to find a broadly diversified index fund or a mutual fund and start investing monthly.
This way you’ll remain invested through market ups and downs without needing to worry about market volatility. You also benefit from dollar-cost averaging because of regular purchases and don’t have to think about market timing. These are just a couple of reasons why many investors are gravitating toward a long-term, passive investment strategy.
Of course, there are still some common 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 (and expensive) software to succeed. All the information long-term investors need is provided by the company itself.
Because, as long-term investors, we are interested in the fundamentals, the most valuable information usually comes from companies’ quarterly and annual reports.
What’s left for the investor to do is to decide whether the company has what it takes to succeed in the long term.
