Long-term investing involves holding investments for longer than one year. It includes holding assets such as bonds, stocks, exchange-traded funds (ETFs), and mutual funds. A long-term investor must be disciplined and patient because he or she must be willing to take on certain risks while they wait for a higher return down the road.
Holding stocks for a long period of time is recommended by many market experts. In the 47 years from 1975 to 2022, the S&P 500 experienced losses in only 11 of those years, making stock market returns quite volatile within shorter time periods. However, investors have historically had a much higher success rate over the long term.
An investor may be tempted to invest in stocks during a low-interest-rate environment, but it makes more sense and produces better results overall to hold on to stocks for the long term. In this article, we explain how you can benefit from holding stocks for a longer period of time.
Benefits of Long Term Investing
1. Better Long-Term Returns
An asset class is a specific category of investments. Fixed income investments (bonds) and stocks, also known as stocks, have the same characteristics and qualities. Which asset class is best for you depends not only on your age, risk profile, and investment goals but also on your capital and investment objectives. Where should long-term investors put their money?
Stocks have generally outperformed almost all other asset classes over the course of several decades. From 1928 to 2021, the S&P 500 returned an average of 11.82% per year. By comparison, three-month Treasury bills (T-bills) returned 3.33% and 10-year Treasury bonds returned 5.11%.
Emerging equity markets offer some of the highest return potential, but also the highest risk. Historically, this asset class has generated high average annual returns, but short-term fluctuations have hurt its performance. For example, the MSCI Emerging Markets Index had an annualized return of 2.89% as of April 29, 2022.
Large and small caps have also posted above-average returns. According to the Russell 2000 Index, which measures the performance of 2,000 small companies, the 10-year return was 10.15 percent. The Russell 1000 large-cap index has averaged a 13.57% return over the past 10 years ( as of May 3, 2022).
2. You Don’t Have To Time The Market
Let’s face it, we’re not as rational and calm as we hope to be. Investors tend to be emotional, which is one of their inherent flaws. When the stock market begins to decline, many people claim to be long-term investors; however, they withdraw their money to avoid further losses.
Contrary to popular perception, most investors do a decent enough job of figuring out which stocks they want to buy. It is the selling that they find tough. You need to sell your investment in order to realize gains and once your stock has amassed a good amount of unrealized gains, your challenge begins.
Let’s say your investment has risen by 25% over a year, which is a phenomenal return. The following year, the market begins to decline, and your investment is now displaying an unrealized gain of 10%. Your brain immediately thinks that you’ve lost 15% gains when in reality, all of this is on paper. You haven’t actually lost anything.
The financial media often reports market declines as ‘wiping out’ a certain amount of money. They also make statements such as ‘investors lost $1 trillion dollars.’ These are nonsensical statements. You will lose or make money only when you sell your investment. Buy and hold removes the pressure of figuring out when to sell since you need to hold onto it for as long as possible.
Short-term traders always worry a lot about getting the exact prices they want on entry. This is because if you’re going to buy at $95 and sell at $96, entering at $95.50 will make a huge difference. You’ll reduce your potential gains by 50%.
When investing over the long term, though, your exact entry price doesn’t matter. After all, your investment horizon is at least 10 years long. A dollar here or there over 10 years’ time will not matter if you invest in a great company with long-term prospects.
More importantly, if you know before you invest that you will have to hold that stock for ten years, you are much more likely to do your homework and follow rational principles. Imagine buying a piece of furniture or renting an apartment for the next 10 years. Would you just rush out without taking a good look at the apartment? Would you fail to do your due diligence? Not likely.
3. Earning Dividends While Compounding Your Wealth
Dividends illustrate why the traditional approach to risk is flawed with respect to income investing in bonds versus capital investing in stocks. You can invest in stocks and still earn a good income. Dividends make this possible.
A stock dividend also allows you to earn an income from your investment whether the stock price goes up or down.
Dividend yields for stocks generally range from two to five percent. Of course, it is possible to achieve higher yields, but you must take certain factors into account.
A stock’s dividend yield is calculated by dividing the amount of the dividend payment by the stock’s price. The higher the payout, the higher the yield. But the share price also plays a role. A falling share price can also drive up the yield. So it’s not that chasing yields is the best way to find good dividend stocks.
It’s a bit like earning rental income on a property you buy. The best part is that, unlike a rental investment, you do not have to work to maintain your investment. You do not have to worry about making payments to tenants, you do not have to do regular maintenance, you do not have to solicit tenants, and so on. You simply invest your money and receive a dividend.
This level of passivity is not possible with any other investment outside of the stock market. And the longer you hold on to your investment, the more income you earn until your effective investment cost goes down. For example, if you paid $200 for stock and received a two percent return each year, you would earn $4 in income from your investment. Once you receive the first payment, you will have earned a realized gain of $4, so your effective cost is now $196.
The longer you hold the investment, the lower the effective cost and the more likely you are to make a profit.
4. Ride Out Highs and Lows in the Stock Market
The stock market is considered to be a long-term investment. This is because it’s not uncommon for stocks to drop 10% to 20% or more in value over a short period of time. Over a period of many years or even decades, investors can ride out some of these highs and lows and generate a better long-term return.
According to stock market returns since the 1920s, individuals rarely lost money investing in the S&P 500 for a 20-year period. Even with setbacks like the Great Depression, Black Monday, the tech bubble, and the financial crisis, investors would have seen gains if they had made an investment in the S&P 500 and held it for 20 years uninterrupted.
Although past results do not guarantee future returns, long-term stock investing generally pays off, if given enough time.
5. Lower Capital Gains Tax Rate
The sale of assets results in a capital gain. This includes personal assets such as furniture and investments such as stocks, bonds, and real estate.
Gains from the sale of a security within one calendar year of purchase are taxable as ordinary income. Short-term capital gains are referred to as such. This tax rate can be as high as 37%, depending on the individual’s adjusted gross income (AGI).
A long-term capital gain is a result of selling securities held for more than one year. Gains are taxed at a maximum rate of 20%. For tax brackets lower than the investor’s, even a 0% tax rate may apply to long-term capital gains.
6. Less Costly
Long-term investing has many benefits, one of which is money. The longer you hold your stocks in your portfolio, the less you have to pay in fees. That makes it less expensive than regular buying and selling. How much does it cost?
You can save on taxes. Gains from stock sales must be reported to the Internal Revenue Service (IRS). This increases your tax liability, which means you pay more. The cost of short-term capital gains may be higher than the cost of holding your stock for a longer period of time.
There are also trading and transaction fees. Depending on the type of account you have and the investment firm that manages your portfolio, you may pay different amounts. For example, if you buy and sell through a broker, you may be charged a commission. However, markups are charged when sales are processed through their inventory. When you trade stocks, these costs are charged to your account. This means that every time you sell shares, your portfolio balance will decrease.
The true impact of paying short term capital gains taxes can be felt in terms of compounding. For example, a $10,000 investment that grows at 7% every year matures to $76,122 at the end of 30 years. Let’s say you pay 15% taxes on this amount. Your final after-tax investment is worth $64,703.
Let’s say you invested $10,000 every year in a one-year investment and that this investment gained 7% as well. Since this is a one-year investment, you’ll sell it and pay a tax rate of 25% on the gains before reinvesting the after-tax amount the following year. How much does this investment mature to after 30 years?
It grows to $46,415. This is a difference of $18,288. In other words, if you had avoided withdrawing your money and paying higher taxes on it at the end of every year, you could have earned close to 40% more money. That’s a pretty significant difference! Short term taxes have effectively cost you 40% over a 30 year period.
7. No Need to Chase Unicorns
A unicorn is that magical stock that increases its value 100 or 1000 times in a short period of time. Many venture capitalists are on the lookout for such stocks, and it is a difficult task. Most often, venture capital investments fail because of the extremely high risk involved.
We see a similar venture capital mentality with people who only want to invest in penny stocks. With buy and hold, you are no longer forced to chase these extraordinary profits because your mindset will change.
You’ll realize that a good investment that returns 10-12% every year, even if it’s a pre-tax gain, is a serious way to build wealth. In the long run, it’s this kind of investment that really makes money, as opposed to looking for the magic stock that goes up 100 or 1,000 times in a short period of time.
The best way to find these unicorns is to follow a long-term holding strategy. That way, you give your investments enough room to actually grow, rather than expecting them to rise by that amount over the course of five or 10 years.
Best Types of Stocks to Hold for the Long-Term
When you buy stocks, you need to consider several factors. You should consider your age, your risk tolerance, and your investment goals, among other things. Once you have a handle on all of these, you can develop a stock portfolio that meets your goals. A general guideline that you can use as a starting point to fit your own situation is as follows:
- Index funds. They track specific indexes, such as the S&P 500 or the Russell 1000, and trade just like stocks. These funds come with a lower cost, however, and you do not have to select specific companies to invest in. These funds offer similar returns to index funds.
- Dividend-paying stocks. You can add value to your portfolio by investing dividends from these types of stocks.
- Growth Stocks. These stocks are generally associated with companies that generate revenue at a faster rate than others. They are also better able to deliver strong earnings results. Remember, though, that this kind of growth comes with a greater risk, so you’ll need to be savvier than novice investors if you want to take this route.
If you’re a beginner in the world of investing, it’s a good idea to consult with a financial professional.
Stock investors can take advantage of many different trading strategies. Those with more experience and larger capital may be able to use short-term trading techniques to make money. For those who are just starting out or can not tolerate too much risk, this may not be suitable. Stocks can help you ride the ups and downs of the market, offer lower tax rates and tend to be less costly if you hold them for the long term.