Why The Long-term Outlook in Investment?

What is the secret to successful investing? The answer will shock you. It is to do nothing. Well, not quite nothing, but our point is that to be successful, you need to limit your activity as much as possible when it comes to managing your investments. Tinkering with them and second-guessing yourself is what causes more losses than any market dips.

This module is going to walk you through the investing philosophy known as “buy and hold” investing. You’ll learn why this is far superior to any other investing approach for new investors.

The Difference Between Speculation and Investment

Before understanding why buy and hold is such a powerful philosophy, we need to take a step back and understand the differences between investing and speculation. The first person who pondered this question was Benjamin Graham in his legendary guide The Intelligent Investor. The guide Warren Buffett frequently refers to as his “Bible.”

According to Graham, investing or an investment operation was something based on we he called “intelligent principles.” This ensured that it had a high probability of success. In contrast, speculation was something that was carried out using unsound principles and had a high chance of failure.

This definition sounds simple enough, but there are many caveats in here. What qualifies as intelligent, and what are unintelligent principles? In the context of the market, we can define an intelligent investment process as being one that takes the financial realities of the market into account.

The first reality to acknowledge about the market is that in the short term, no one can predict the direction of prices. This is because, in the short term, stock prices are fueled by emotion. Emotions which arise from the myriad of psychological biases that human beings have.

For example, you hear of everyone jumping into a hot new stock, and see the media telling you that this stock is a sure thing. You’re likely going to think that this stock is great. This herd mentality or peer pressure is just one example of unconscious biases we carry. This behavior has been a factor since Graham’s time (during the Great Depression) and is still present to this day.

To further illustrate how flawed behavior affects the markets in the short term, let’s discuss “Flash Crashes.” A flash crash is a market crash (defined as any drop of 10% or more) that occurs over the span of a few minutes or even seconds. Flash crashes have become more common these days thanks to the advent of algorithmic trading, a method of automatic trading based on pre-determined variables.

Two “Flash crash” incidents occurred in the past decade that perfectly illustrate the short term drivers of the market, and the irrational nature of human behavior. The first occurred on August 24th 2015. The minute the markets opened, they immediately fell by 5% before gaining back most of their gains by the end of the day.

The Grandaddy of all flash crashes occurred on May 6th, 2010 when a single trade caused the entire market to lose 1,000 points (roughly 9% of its total value) and then rise right back up in under 15 minutes.

Many stocks reached unthinkably low prices. Accenture, the global consulting conglomerate, actually saw its stock touch zero before rising back up to $41.09. Similar massive movements occurred in the crash of 2015 as well. All of these movements led to much hand wringing in the media.

Complex reasons were put forward. The widely accepted reason for the 2015 crash was that traders were nervous after the end of the previous session which was on a Friday. The market had declined and they weren’t sure what was going to happen over the weekend. The Chinese markets, which open before the American ones do, opened lower and hence this fueled a rush of selling in America as well.

Let’s just take a step back from all of this madness. If the market was to be believed, a 54 billion dollar company at the time, such as Accenture, was temporarily deemed as being worth nothing because a bunch of Chinese traders happened to sell their stocks in China. Furthermore, the market then decided that the company was worth 54 billion dollars once again by the end of the day.

Does any of this sound logical? Let’s say you own a piece of farmland that is consistently producing high-quality crops. Let’s say some person comes up to you and declares that the price of this land is now worth zero. He goes away and then returns eight hours later and tells you that the property is now worth $1m million dollars. You’d rightly think that this person is a nut!

Yet when the stock market does the same thing, we invent intelligent-sounding drivel such as “traders were nervous over the weekend and Chinese selling triggered a wave of sell orders on the open.” In the 90s it used to be the Arabs who used to trigger all kinds of havoc in the market (supposedly). These days, it’s the Chinese.

There’s a political lesson in there somewhere, but as far as intelligent investment goes, it’s hard to see us learning anything of note. What we can learn is that the markets are incredibly irrational over the short term and that tailoring your portfolio to these moves will only result in your being exposed to this madness. So what is the best approach to adopt?

Short Term Trading Versus Long Term Investing

Short term trading involves all kinds of risks because of moves such as these. In essence, a trader is attempting to gauge how the market feels about the stock. Here’s an experiment for you to conduct. Walk over to your partner and try to guess how they’re feeling about something. You might be able to guess what is wrong some of the time, but not all the time.

Now walk over to a stranger and try to guess how they feel about something. You don’t know this person, but your task is to guess anyway. How often do you think you’ll succeed? Finally, try to imagine what some random person on the other side of the planet feels about Walmart’s stock price. You don’t know anything about this person or what their motivations are. All you know is that they have an opinion about the price of Walmart stock.

You’d come back saying that this is a hopeless task. How could you possibly know any of this? Well, this is what traders try to do every day. They seek to take advantage of short term price moves, and as you’ve already seen, these moves don’t occur thanks to logic or business reality. They occur due to emotion. Often this can be as simple as a large financial institution placing a big sell order, so everyone else starts selling as well. This is the herd mentality in action, as we previously mentioned.

It stands to reason that if you wish to take advantage of these moves, you need to be able to predict the emotions other traders have concerning the stock. In real life, it is impossible to do this, but traders think that using indicators and angled lines on a chart will somehow solve the issue for them.

Does this sound like an intelligent thing to do? Welcome to the world of speculation! Speculation isn’t restricted to merely trading. It is anything that is carried out in an unintelligent manner, and this encompasses many things. For example, you could be deluded in thinking that you know everything about a business opportunity. If you were to go ahead and place your money in it without doing your due diligence, this would be speculative and not an investment operation.

Given that stock market prices are driven by emotion in the short term and that we cannot predict emotions, it stands to reason that we need to take a longer-term view of the market. There is an excellent reason to do this. This is because emotions tend to exhaust themselves over the long run. As Benjamin Graham said, in the short term the market is a voting machine but in the long term, it’s a weighing machine.

Think about your own life and set the markets aside for a second. How often have you seethed in anger for a few minutes, and then forgotten all about it a week, a month, or a year later? Do you remember if you lost your temper this time last year? We’re not talking about situations where the emotion was justified thanks to life events. We’re talking about those issues that seem petty in the long run. Your spouse or partner placed their shoes over yours and dirtied them, and you lost your temper. The dog decided to pee all over your shiny new carpet and so on. The delivery driver was 10 minutes late because he got lost. What would have happened if you had followed the lead of that emotion and made huge changes in your life? Would this have been the smart thing to do?

Of course not! Instead, you gave yourself time to calm down, and when you did, you forgot all about it and moved on. The same thing works in the market as well. On August 24th, 2015, the actions of Chinese traders were extremely crucial. Yesterday, the markets couldn’t care less about what Chinese traders did. It’s all emotional.

Over the long run in the market, the stock price of a company reflects its underlying earnings growth. Using the example of farmland that you own, the true value of the land is the crop yield it produces. It also depends on how profitable farming is as a business. Are you getting good prices for your crops? If so, the land is quite valuable if it produces high-quality crops. If not, it isn’t as valuable.

The same applies to companies. One key element new investors miss is that there are real companies behind those little symbols you see on the screen. Buying shares is the same as owning a percentage of the company. These are businesses with suppliers, customers, competitors, and employees. All of these factors come together to generate profit and loss. The more profit they make, the more prosperous the company is, and this is reflected in the stock’s price over the long term.

While you cannot predict human emotion, you can make intelligent decisions about a company’s business prospects. You can evaluate their economic outlook and that of the business they’re operating in. This process removes emotion and market sentiment from the equation and is the only way to make money in the long-term reliably.

Understanding the Costs of Investing

Now that you understand why having a long term view is essential, it’s time to take a look at costs. Participating in the market is not free. You will need to pay your broker commissions when buying or selling stocks. This can be off-putting when you want to make an investment of $100, but you have to pay $10 in commissions to execute the trade. Fortunately, these days, this isn’t a big deal because there are a ton of reputable brokers who offer very low and even zero commission accounts. We’ll be talking about our personal favorite later on in this guide.

While commissions are less of an issue than they used to be, taxes haven’t changed. As it relates to the stock market, you will pay taxes on capital gains and dividends. Dividends are distributions from the company to you, and as such, they represent passive income. You don’t have to pay anything other than the price of a share to earn a dividend. As such, paying taxes on them isn’t too painful since they effectively reduce the cost of your investment to begin with. We’d like to add that companies are not obliged to pay dividends, and not all of them do.

Capital gains taxes operate differently. Capital gains are the profits you make when you sell your investment. This is the difference between the sale price and the purchase price of your investment. For example, if you buy 1 share of Disney at $100/share and then sell it once the price reaches $120, that $20 difference is your “capital gain”. Taxes on capital gains will reduce your overall profit because capital gains do not happen to be free money like dividends are.

One area that can confuse new investors is when you pay capital gains tax. You only pay capital gains after you sell your investment. Therefore, the more you sell, the more are the taxes you pay. In turn, the more often you sell, the lower your overall gains are going to be.

Then there’s the issue of long term versus short term capital gains taxes. The short term tax rate, which is levied on investments that lasted less than a year, is the same as your income tax rate. The long term rate falls between zero to 40% depending on your income tax bracket and which country you are paying your taxes.

Therefore, the longer you hold onto your investments, the less you pay in taxes. If you never sell your investments, you’ll never pay capital gains taxes. In the real world, you will want to sell your investments at some point since this is the only way you’ll get to enjoy the fruits of your investment unless you want to pass them onto your next of kin in your will. Our point is, it is smart to delay the decision to sell within the first year of owning a stock.

Another cost you need to take into account when investing is inflation. Inflation is a hidden cost, and many investors fail to take notice of this. The value of a dollar tomorrow is not the same as a dollar today. The best way to reduce the impact of inflation on your gains is to hold onto your investment for as long as possible so that it has the greatest chance to appreciate in value. We will explain more about how to take inflation into account in our module on calculating the true value of a business.

It should come as no surprise to you that stocks rise at a far greater distance over the long run than they do in the short run. A good way to think about this is to ask yourself: Can you get more done in a minute or over a year? The answer is obvious. Hold onto your investments for as long as possible and give them a chance to make money.

By combining the above principles, it is clear that the most intelligent investment decision you can make is to buy and hold stocks for as long as possible. Leave the constant jumping in and out to the traders and other speculators. Resist everything that can potentially cause you to exit early or trade too much in a single stock.

This means you need to prepare well by researching your investments and then investing your money in the right way. Once this is done, you can minimize taxes and transaction costs by holding for long periods. The longer you hold onto your investments, the longer they have to potentially gain more, and this reduces the impact inflation has on your returns.

Read Books to Learn The Right Investment Mindset

A large part of successful investing is about Mindset. So I read many mindset books.

Recently, I read Rich Dad Poor Dad and found it quite interesting.

Through autobiography and personal experience, Rich Dad Poor Dad explores the steps to becoming financially independent and wealthy. 

The writing style and framework of this book are narratives. This book focuses primarily on anecdotes with nuggets of supposed wisdom, not technical insight or investment math.

He compares the lessons he learned from his biological father (an intelligent, but financially inept father) with the lessons that he learned from his friend’s father (an uneducated, but smart and wealthy father).

It weaves through Kiyosaki’s life as he learns from his rich father and rejects advice from his poor father (thereby eclipsing typical working-class mindsets).

Some of the concepts in this book are, however, questionable. Read my Rich Dad Poor Dad review to learn more about my insights about the book.

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