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Long-term investing: Everything you need to know

At a glance:

  • Benefits of long-term investing

  • Drawbacks to long-term investing

  • Investments best suited for long-term investing

  • Volatility of single stocks

  • Volatility of the stock market

  • Why stocks perform the best

  • Long-term investing strategies

  • Summary of long-term investing

Investors who plan to hold onto their securities for a while may be investing for the long term.

They hold their investments for a reason: long-term investing offers rewards that short-term investing does not. It is a strategy used to attain specific goals.

Long-term investing may be called a "buy and hold" strategy. While the long-term benefits are attractive, sometimes it takes real stamina to hang on to some investments through rough markets.

(Getty)
(Getty)

Benefits of long-term investing

One of the main concerns for any type of investing is market volatility. Volatility measures the degree to which prices change over time. Another way to think of volatility is in terms of price swings.

The greater and more frequently an investment's price swings, the higher its volatility. Investments with high volatility have a high degree of risk because their prices are unstable.

The importance of volatility and time to long-term investing

It is important to note that short-term volatility is not necessarily indicative of a long-term trend. A security can be highly volatile on a daily basis but show long-term patterns of growth or stability. Some investments may maintain purchasing power over time, but can fluctuate wildly in the short term.

The advantage of long-term investing is found in the relationship between volatility and time. Investments held for longer periods tend to exhibit lower volatility than those held for shorter periods. The longer you invest, the more likely you will be able to weather low market periods.

Assets with higher short-term volatility risk (such as stocks) tend to have higher returns over the long term than less volatile assets such as money markets.

The many advantages of staying put

It is very difficult and risky to time the market. Many people panic when they see reports of a falling stock market. However, staying invested in the market over the long term has historically paid off. Although short-term fluctuations seem random, the stock market tends to reflect the overall growth and productivity of the economy in the long run.

Putting your money in long-term rather than short-term investments also provides tax advantages on capital gains. Often long-term gains—those held over 12 months (6 months for Puerto Rico)—are taxed at rates below your income tax bracket. Short-term gains, on the other hand, are taxed as regular income.

Long-term investing might also save you other expenses, such as transaction costs from active trading. Certain mutual funds may defer sales charges if you hold your shares for a long period.

Common reasons for long-term investing

There are many reasons for you to invest for the long term. Saving for retirement or a college education, for a future house, or to provide funds for the long-term care of your parents are all common goals of long-term investing.

The next step

Once you decide to become a long-term investor, you'll need to choose some investments and strategies based on your risk tolerance and desired returns—investments such as growth stocks and long-maturity bonds as well as strategies such as buying and holding, and tax sheltering.

Finally, before you decide to make a long-term investment, you must keep in mind that along with its benefits come the drawbacks of limited liquidity and increased business risk.

Drawbacks to long-term investing

While long-term investing offers many advantages to investors, it also carries with it disadvantages and risks that need to be considered, including liquidity, business risk, and the effects of interest rates and inflation.

Liquidity risk

The ability to convert an investment into cash is called liquidity. A liquid investment is one that is easily changed into cash. An illiquid investment is not easily converted into cash. An investment is said to be marketable if it can be easily sold to a readily available market.

The disadvantage of many long-term investments is that many are illiquid. Others may be converted into cash, but only with the risk of significant loss. Long-term investments are therefore not ideal for earning income to meet upcoming obligations such as living and medical expenses.

Business risk

Holding onto investments for longer periods also exposes you to increased business risk. This is the risk that the business you invest in will fail or become less profitable, decimating the value of your investment.

Consider inflation and interest rate changes

Long-term, fixed investments such as bonds also run the risk that their values will decrease due to a rise in interest rates. Inflation must also be taken into consideration when planning on future returns from long-term investments. Your investment returns must outpace inflation in order to increase your purchasing power.

Long-term investing generally offers the potential for higher returns; however, you must keep in mind the risks and disadvantages as well.

Volatility of single stocks

Individual stocks tend to have highly volatile prices, and the returns you might receive on any single stock may vary wildly.

If you invest in the right stock, you could make bundles of money.

Here is an example

For instance, Monster Beverage (MNST), the maker of the popular energy drink, had the highest 15-year return of all S&P 500 stocks as of February 2017.

If you had invested $10,000 in Monster in the late 1980s, your investment would have been worth over $5 million by February 2017.

But you could also lose wildly

On the downside, since the returns on stock investments are not guaranteed, you risk losing everything on any given investment.

In the early 2000s, there were hundreds of examples of dot-com investments that went bankrupt, and during the 2008 financial crisis, once-storied Lehman Brothers collapsed entirely and Wall Street cornerstone Merrill Lynch was acquired by Bank of America (BAC) at a fraction of its pre-crisis value.

But most stocks aren't like this

Between these two extremes is the daily, weekly, monthly, and yearly fluctuation of any given company's stock price. Most stocks won't double in the coming year, nor will many go to zero.

But do consider that the average difference between the yearly high and low stock prices of the typical stock on the New York Stock Exchange is nearly 40%.

In addition to being volatile, there is the risk that a single company's stock price may not increase significantly over time.

For instance, by late 2017, J.C. Penney (JCP) stock had lost more than 21% per year on average over the previous three years, declined 31% per year on average over the previous five years, and long-term shareholders had suffered an average 5.8% decline per year over the previous 15 years.

This compared with a 7% average annual return for the S&P 500 Index over the same time period, and a nearly 6% return for the bond market.

Clearly, if you put all of your eggs in a single basket, sometimes that basket may fail, breaking all the eggs.

Other times, that basket will hold the equivalent of a winning lottery ticket.

Volatility of the stock market

One way of reducing the risk of investing in individual stocks is by holding a larger number of stocks in a portfolio.

However, even a portfolio of stocks containing a wide variety of companies can fluctuate wildly. You may experience large losses over short periods.

Market dips, sometimes significant, are simply part of investing in stocks.

History gives clues

For example, consider the Dow Jones Industrial Average, a basket of 30 of the most popular, and some of the best, companies in America.

If during the last 100 years you had held an investment tracking the Dow, there would have been 10 different occasions when that investment would have lost 40% or more of its value.

The yearly returns in the stock market also fluctuate dramatically.

Trader Thomas McArdle works on the floor of the New York Stock Exchange. (Photo: AP Photo/Richard Drew)
Trader Thomas McArdle works on the floor of the New York Stock Exchange. (Photo: AP Photo/Richard Drew)

The highest one-year rate of return of 67% occurred in 1933, while the lowest one-year rate of return of negative 53% occurred in 1931.

It should be obvious by now that stocks are volatile, and there is a significant risk if you cannot ride out market losses in the short term.

But don't worry: There is a bright side to this story.

Over the long term, stocks are best

Despite all the short-term risks and volatility, stocks as a group have had the highest long-term returns of any investment type. This is an incredibly important fact!

When the stock market has crashed, the market has always rebounded. And over the very long term, stocks have outperformed bonds on a total real return (after inflation) basis, on average.

If you had deplorable timing and invested $100 into the stock market during any of the seven major market peaks in the 20th century, that investment, over the next 10 years, would have been worth $125 after inflation, but it would have been worth only $107 had you invested in bonds, and $99 if you had purchased government Treasury bills.

Traders Peter Tuchman, left, and his son Benjamin Tuchman, wear "Dow 28,000" hats at the close of trading on the floor of the New York Stock Exchange. (Photo: AP Photo/Richard Drew)
Traders Peter Tuchman, left, and his son Benjamin Tuchman, wear "Dow 28,000" hats at the close of trading on the floor of the New York Stock Exchange. (Photo: AP Photo/Richard Drew)

In other words, stocks have been the best-performing asset class over the long term, while government bonds, in these cases, merely kept up with inflation.

This is the whole reason to go through the effort of investing in stocks.

Again, even if you had invested in stocks at the highest peak in the market, your total after-inflation returns after 10 years would have been higher for stocks than either bonds or cash.

Had you invested a little at a time, not just when stocks were expensive but also when they were cheap, your returns would have been much greater.

Time is on your side

Just as compound interest can dramatically grow your wealth over time, the longer you invest in stocks, the better off you will be. With time, your chances of making money increase, and the volatility of your returns decreases.

Some numbers to illustrate the point

From 1928–2018, the average annual return for the S&P 500 stock index (including reinvested dividends) for a single year has ranged from negative 43% to positive 54%, while averaging about 10%.

Five-year average annualized returns have ranged from about negative 12% to positive 24%.

These returns easily surpass those you can get from any of the other major types of investments.

Again, as your holding period increases, the expected return variation decreases, and the likelihood for a positive return increases.

This is why it is important to have a long-term investment horizon when getting started in stocks.

Investments best suited for long-term investing

Long-term investors seek to build portfolios that will gain maximum value over time. Certain kinds of investments are particularly well suited to helping investors take advantage of long-term growth trends.

Growth stocks and growth mutual funds

Growth stocks are stocks from companies with a strong potential for future growth. The earnings of growth stocks are expected to grow faster than the market average. More volatile and with few dividends, the true potential of growth stocks lies in their future prices.

They are well suited for the long-term investor willing to take a chance and hold on through short-term ups and downs. Growth mutual funds, which invest in a variety of growth stocks, are a slightly less volatile way to invest in growth stocks.

Bonds with long maturities

Another typical investment for the long-term investor is bonds with long maturities of ten or more years. Although bonds with long maturities are more at risk from changing interest rates, they also offer higher returns than shorter bonds to compensate for this risk.

Other investments

The long-term investor can also invest in other assets that may take longer to grow in value but show high returns over time. These include real estate, leases, and collectibles.

Investors who are willing to wait for their money can take advantage of more volatile stocks, as well as bonds and other investments that offer higher returns to reward the investors' patience.

Why stocks perform the best

While historical results certainly offer insight into the types of returns to expect in the future, it is still important to ask the following questions: Why, exactly, have stocks been the best-performing asset class?

And why should we expect those types of returns to continue? In other words, why should we expect history to repeat?

Here is why

Quite simply, stocks allow investors to own companies that have the ability to create enormous economic value.

Stock investors have full exposure to this upside. For instance, in 1985, would you rather have loaned Microsoft money at a 6% interest rate, or would you have rather been an owner, seeing the value of your investment grow several-hundred fold?

Specialist Peter Mazza, left, and trader James Riley work on the floor of the New York Stock Exchange. (Photo: AP Photo/Richard Drew)
Specialist Peter Mazza, left, and trader James Riley work on the floor of the New York Stock Exchange. (Photo: AP Photo/Richard Drew)

Because of the risk, stock investors also require the largest return compared with other types of investors before they will give their money to companies to grow their businesses.

More often than not, companies are able to generate enough value to cover this return demanded by their owners.

Bondholders don't enjoy that potential

Meanwhile, bond investors do not reap the benefit of economic expansion to nearly as large a degree.

When you buy a bond, the interest rate on the original investment will never increase. Your theoretical loan to Microsoft yielding 6% would have never yielded more than 6%, no matter how well the company did.

Being an owner certainly exposes you to greater risk and volatility, but the sky is also the limit on the potential return.

Long-term investing strategies

Long-term investors use a number of specific strategies designed to help their portfolios grow in value, as well as to avoid losing their gains to taxes and short-term market changes.

Reinvesting dividends

Certain types of investments, such as stocks, share some of their company profits with their investors. These profits are called dividends. Investors can receive dividends in the form of cash, or they may reinvest them to buy more securities. Reinvesting dividends to build future value is one strategy used by long-term investors.

Buying and holding

Long-term investors also buy and hold. To buy and hold simply means to buy an investment and hold onto it for the long term, rather than actively trading it.

Tax shelters

You can also invest in a variety of tax shelters. Tax shelters are investments designed to reduce taxes. Tax shelters provide income tax reduction through deductions or deferments. They can be used to reduce taxable income, offset income with losses, or create tax credits. Certain types of tax shelters can be very risky investments. Rental real estate is one example of a commonly used tax shelter.

Another strategy for reducing taxes on your long-term investments is to invest in tax-deferred accounts such as individual retirement accounts (IRAs) or 401(k) plans. These types of investments allow your investment to grow tax-deferred until you withdraw the funds at retirement. Early withdrawal penalties are charged on most types of tax-deferred accounts.

A final note

These strategies can help when your investment goals permit you to take advantage of the benefits of long-term investing. Long-term investment strategies can be particularly useful for college savings, retirement planning, and other goals that allow you to hold your investments for an extended period.

Summary of long-term investing

Choosing a long-term investment strategy depends on your investment goals. Investors saving for retirement or college planning have long-term investment goals for which a long-term strategy might be suitable.

If you have long-term investment goals, you will need to choose some investments and strategies based on your risk tolerance and desired returns—investments such as growth stocks and long-maturity bonds as well as strategies such as buy and hold and tax sheltering.

Finally, before you make a long-term investment, you must keep in mind that along with its benefits may come the drawbacks of limited liquidity and increased business risk.

This content was created in partnership with the Financial Fitness Group, a leading e-learning provider of FINRA compliant financial wellness solutions that help improve financial literacy.

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