Thursday, February 24, 2011

Benefits of Long-Term Investing

Imagine a cross-country car race that starts in downtown Houston during rush hour. One racer sees bicycle messengers speeding by in the stop-and-go traffic. Becoming impatient, he jumps out of his car, trading it for a bicycle. Once out of Houston, as other racers still in their cars pass him, he quickly realizes his short-term decision was unwise in light of his long-term goal of winning the race.

It may seem rather silly for this racer to trade in his car for a bike, yet investors do the same thing every day. They lose sight of the strategy that it will take to get their prize. Although many investors claim to understand the benefits of long-term investing, their actions often show a short-term focus.

So, what is long-term investing? And why is it a tenet of MTR Financial's investing philosophy?  Long-term investing is being committed to a sound investment plan—one that starts with a proper asset allocation appropriate to your risk tolerance—over a length of time, such as five to 20 years.  More importantly, though, long-term investing is a mindset that gives you perspective and discipline as you work toward your financial goals—and can keep you from making costly mistakes based on short-term perceptions.

Benefit 1: Maximize your wealth
The wealth you can accumulate over your lifetime is determined by three factors: (1) the amount you save and invest, (2) the return you earn on your investments, and (3) how long your money compounds, generating earnings from previous earnings. The long-term mindset is key to this last point: how long your money compounds from reinvesting your investment earnings. This is something most investors have direct control over. The earlier you start and maintain the long-term outlook, the more time compounding has to work its magic.

Benefit 2: Prevent costly mistakes
Losing sight of the long term and thinking you can time the market by exiting at the peak and re-entering the market at the trough over the short term is a big mistake. Timing market shifts correctly is nearly impossible, although making modest adjustments to your strategic allocation based on current market analysis can add value. However, we continue to see investors making wholesale market timing bets.

Why can market timing be so costly? Because returns are often concentrated in short periods. For example, in March 2009, US stocks were up 9%. Nearly 90% of the month's recovery came in just eight trading days following the low point of the stock market.

Portfolio studies have been performed to see what happens when you miss the top days in the market. The research, looking at returns from 1990-2009 shows that missing the market's top 10 days cut the return by nearly half on a portfolio of stocks, represented by the S&P 500 index.  Missing the top 20 days dropped the return below even Treasury bills (T-bills). And missing the top 40 days—that's 40 days out of 20 years, fewer than 1% of the trading days—produced a negative return. You can see how a small number of trading days can equate to large differences in return.

Benefit 3: Lower your risk
Having a long-term mindset and lengthening the time you hold investments can often reduce the probability of experiencing negative returns.  Studies have been done on the highest return, lowest return and average annual return of the S&P 500 over various holding periods from 1926. The findings show that as you move from a one-year holding period to a three-year, 10-year, and finally to a 20-year holding period, the number of negative returns experienced goes down. In fact, there's never been a 20-year period with a negative return.

Stay focused
How can you keep your long-term state of mind the next time you're tempted by a short-term decision?  Remember that keeping a long-term state of mind doesn't mean ignoring your portfolio. It means developing a plan based on long-term expectations, not short-term trends. Along the way there will undoubtedly be some fine-tuning. Investing for the long-term can help maximize wealth, prevent costly mistakes and lower the downside risk in your portfolio.

Or, to quote legendary investor Warren Buffet: "Someone is sitting in the shade today because someone planted a tree a long time ago."