You might have already defined your long-term financial goals and decided to make your money work for you to maintain and grow your purchasing power. So now, you are ready to get started with investing. Understandably, you may have some more questions. When is the best time to start investing? How long should I hold my investments? Aren’t we in a recession – why should I invest now? If you get one thing from this article, let it be this: what is most important is your time in the market, not timing the market.
What are the benefits of long-term investing?
You may have heard the good old advice in the past to “buy low and sell high” to maximize the impact of short-term market movements. This is a prominent tactic amongst “day traders”, many of whom spend hours a day trading, trying to beat the system. Unfortunately, the odds are stacked against this type of strategy. In fact, studies have shown that more than 97% of day traders lose money over time, and less than 1% of them break even. In most cases, they achieve the exact opposite and end up “selling low” when the stock price plummets and miss out on the financial returns when the market rebounds. Then they have no choice but to “buy high” to catch up with the booming prices when the investment starts to climb to new heights. Essentially, the risk in trying to time the market with such a short-term outlook is significantly greater than if you invest your money in a diversified portfolio and let it grow over time.
While everyday ups and downs can be nerve-racking, extending your investment horizon for years (the time you hold money in investments for) can help you experience a smoother ride. It can help you avoid overreactions to short-term market movements, alleviate the impact of inherent human biases and reduce transaction costs. Basically, investing your money in good companies and leaving it there means that neither the short-term market wobbles nor your short emotional fuse will hurt your potential gains. Your patience will eventually be rewarded. The following time-tested principles illustrate the benefits of long-term investing.
Volatility is normal: resist overreactions to short-term market movements
Markets are volatile by nature, but short-term volatility does not necessarily indicate a long-term trend. Some investments may show drastic fluctuation in a single day but may demonstrate growth and stability and maintain purchasing power in the long run.
Dollar cost averaging: a winning strategy for long-term investors
The markets may temporarily decline due to unexpected events like pandemics and geopolitical conflicts but have always recovered over time. For example, the collapse of stock markets due to the COVID-19 pandemic was followed by strong market gains until the end of 2021. Meanwhile, large fluctuations allow long-term investors to employ dollar cost averaging, the strategy of disciplined investors. Dollar cost averaging is a strategy that involves investing a fixed amount of money at regular intervals, regardless of the price of the investment. The idea is to reduce the impact of short-term fluctuations on the overall purchase. By investing the same amount of money at regular intervals, rather than investing a lump sum all at once, you can average out the price you pay for the investment over time.
For example, let’s say you want to invest $500 in a particular stock. Instead of investing the entire $500 all at once, you could choose to invest $100 every month for five months. This means that if the price of the stock goes up, you will buy fewer shares, but if the price goes down, you will buy more shares. Over time, this can help to reduce the impact of short-term price fluctuations and potentially increase your overall returns.
Buy and hold: overcome the temptation to tweak your portfolios constantly
Legendary investor Warren Buffet once stated – “Our favorite holding period is forever.” It is not surprising he’s found success with this mindset as a long-term investment approach mitigates the impact of inherent human biases. Dalbar’s Quantitative Analysis of Investor Behavior has consistently shown that the returns of average investors underperform the overall market due to their behavioral biases – “investors are still their own worst enemies.” Behavioral economics and cognitive psychology have identified various mechanisms involved, such as the illusion of knowledge, risk aversion, fear of regret, etc. People’s illusion of knowledge leads them to believe they can time the market and win, but they often experience lower returns than the market.
This is magnified by loss aversion, which poses that people tend to feel more pain from losing something than pleasure from gaining something. Loss aversion suggests the pain of losing $10 feels about 2x greater than the pleasure of gaining $10. These behaviors lead to an overemphasis on short-term performance resulting in rapid trading when investments have a short-term gain. Our human nature to avoid loss in the short term prevents us from reaping the benefits of long-term investments.
In addition, excessive trading will generate high transaction costs. Some trading platforms even capitalize on this human nature that encourages frenzied short-term trading because it earns them revenue for every transaction. This works in the company’s favor because they generate money when their users trade more, even if the trades are commission free.
Tax efficient investing: pay lower taxes on long-term investment gains
In addition to lower transaction costs, another benefit of long-term investing is that long-term capital gains are taxed at lower rates. Long-term capital gains (those from investments held for longer than a year) are taxed at rates below your income tax bracket. On the other hand, the gains from investments held less than a year are taxed like regular income, which can be as high as double the rate of long-term capital gains tax. Less tax for more gains? Sign me up!
Investing doesn’t need to be overwhelming. Make 2023 your year to claim financial autonomy, whether it’s understanding your financial situation better or making your debut into the investment world. Along the way, FLIT Invest is here to help increase financial literacy of all our users and to drive change through their dollars. Set your goals and start making an impact today!
Footnote 1: Content is for informational and educational purposes only. Any views, strategies or products discussed may not be appropriate for all individuals and are subject to risks. Investors may get back less than they invested, and past performance is not a reliable indicator of future results. The information contained herein should not be construed as, and may not be used in connection with, an offer to sell, or a solicitation of an offer to buy or hold, an interest in any security or investment product. Investors should carefully consider the investment objectives and risks as well as charges and expenses of a mutual fund or ETF before investing.
Footnote 2: FLIT Invest does not provide tax, legal or accounting advice. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.
