The one common advantage to long-term investing is higher returns. That’s it – you can click out of this article now!
Higher returns translate to more money. But are investors only chasing more money?
No, they seek the benefits and the lifestyle that they can create with that wealth. Beyond money for money’s sake, the real advantage is freedom.
With diamond hands and a patient mindset, you can turn your investments into real wealth and create freedom on your terms. Financial freedom means you have complete control over your time and are not living paycheck to paycheck. You can travel, volunteer, pursue your hobbies…whatever floats your boat.
Long-term investments and higher returns have a few different effects on your prospects for wealth generation, compared with investing in a more volatile crypto market.
1. Reaping the Risk and Reward Tradeoff
A common mantra amongst investors is:
Time in the market is better than timing the market.
A long-term investment strategy is much more likely to generate personal wealth. Earning money on your money accelerates its growth over time due to compound interest. For comparison, your salary increases over time but is statistically likely to level off at the mid-point in your career and not experience significant gains. On the other hand, investment monies grow exponentially, thriving off of your assets’ returns.
The efficient markets hypothesis states that a stock’s price reflects all current information on that stock. The stock’s true market value emerges in the long run as the effects of short-term volatility are factored out. As a result, an investor does well by taking a long-term, passive investing approach. This graphic illustrates the favorable risk-reward tradeoff.
As holding time increases, then the possibility of negative return decreases as the average total return increases. The risk of negative return decreases faster than the growth in average return.
Additionally, there are varying risks and rewards to be had in different asset classes. It would help if you balanced your long-term investment portfolio with other asset classes such as bonds, stocks, and real estate to thrive in different market conditions and mitigate the effects of a downturn in a single asset class. Every asset class will have its own merits and disadvantages.
The goal of diversifying like this is to average out the risk and reward tradeoff, and maintain prospects for growth over the long term.
2. Lower Tax Rates
Of life’s certainties, one must be taxes. The US tax code is long and complex but it uses two taxation scales for investments – one for short-term holdings and another for long-term ones. The tax code is designed to incentivize actions that serve the nation’s economic interests.
According to the IRS:
The tax code now contains a variety of provisions intended to encourage savings and investment and –through them, growth.
For instance, an investment in real estate means a property that can provide shelter to someone or provide space for a business to operate out of. An investment in a company’s stocks gives it capital to launch a business, sustain its operations, or fund development projects. Capital investment in productive assets (e.g., real estate, bonds, stocks) promotes growth and benefits society. Such activities take years to have an impact. Hence the government is incentivizing long-term investments.
As a reward, the government taxes the profits from long-term investments at lower rates. Note that profits from an investment are called capital gains, and losses are referred to as capital losses. See the 2021 long-term capital gains tax rate brackets below. It uses your total taxable income, which includes income from your job and other sources.
The IRS defines long-term investing as holding an investment for a period of 1 year or longer. In contrast, short-term capital gains are taxed and treated as earned income, adhering to the same scale.
Assume you are a single filer and make $40,000 in earned income a year.
If you make a $10,000 profit from short-term investments, then you owe 22% tax on the profit. This comes out to $2,200 of tax!
Conversely, if you held the investment for at least a year and sold for $10,000 profit, then you owe 15% tax on it. This comes out to $1,500 of tax – a $700 difference!
Holding and focusing in the long term reduces your short-term tax bill and helps you keep your money in an asset to compound in value over time.
3. Higher Odds of Success
With a longer time horizon in the span of years, you significantly increase your odds of success in the market.
According to Nutmeg, if you keep an asset for at least 10 years, your risk of loss likely declines from 50% to less than 10%! If you hold for a 15-year period, then the risk of loss falls to 0%!
Looking at the below chart, Nutmeg shows that holding an asset for 6 years increases the likelihood of positive returns to 90% and becomes 95% at 8 years! By simply holding for at least 6 years, you have a solid opportunity to earn and maintain your investment gains with better odds than the lottery.
Depending on your goals and desired return, you can forget about holding for 30 to 40 years. You can utilize a more near-term, short-term investment strategy for goals, such as saving for a home. Keep in mind that short-term investments carry more market risk due to a shorter time horizon which invites more volatility.
Bringing this analysis down to a short-term time frame, see this breakdown.
- Holding a stock for a day has the same odds of a coin toss – this is one of the reasons why day traders fail
- Holding for a month has an almost 2/3rds shot at as a positive return and up to 82% at 1 year
- An investor can expect positive returns relatively early on. Treating your holdings as long-term investments allows positive returns to compound and grow exponentially in value – unlocking the true benefits of investing in the market.
However, this should not be taken as a guarantee of an asset’s performance. If the company or underlying asset does not have solid business fundamentals or value propositions, its price may stagnate or decline over the long term. As you build your portfolio, research and select assets that you see performing well in the future. A less laborious, passive investing approach through broad market-based ETFs and index funds will produce results that meet the market’s performance with much less effort.
Attain Financial Freedom through Long Term Investment!
This is what it all boils down to – the ultimate goal of personal finance! It is about achieving the dream a select, persistent few investors will actually reach. Financial freedom entails living out your dream life and shaping your future on your own terms.
Attaining financial freedom is achieved when your long-term investment in assets will produce a return sufficient to cover your basic needs and lifestyle activities.
Financial freedom starts as a vague idea, but if you reflect on what you care about and the things you enjoy – you’ll get an idea of what it means to you. From there, you can plan backward to see what steps to take to make that vision a reality.
No matter the vision – financial freedom is based upon a foundation of security that takes care of your basic needs. That security is founded upon long-term investments and the return you see from them.
Frequently Asked Questions – FAQ
Q: How “long” is long term? How many years are we talking about?
A: It depends on your goals.
Q: How much money should I set aside for investing?
A: The answer varies depending on the person and their financial situation. Usually, a few hundred dollars a month is a good starting point, but it depends on how much you can contribute.
Using a pay yourself first mentality, you review your expenses and cut back where you can to free up money for savings. First, you come up with a desired savings goal based on your after-tax pay. Then, You review your expenses and categorize them by needs and wants. Lower your wants spending to free up cash for saving and investing. Finally, write a new monthly budget to set money aside for saving and needs first before you spend on wants.
We recommend maintaining enough liquidity (cash in a checking or savings account) to cover your usual expenses and an emergency fund for 3-6 months of basic living expenses. Set the emergency fund before you start investing.
Having an emergency fund protects you, so you can use this fund in the worst-case scenario instead of liquidating your investments.
Q: What kind of assets should I invest in for the long run?
A: It is recommended that an investor diversify holdings across the different asset classes (e.g., stocks, bonds, real estate, etc.). The exact allocation depends on your goals and financial situation. Overall, if you have more time to invest, you buy and hold more stocks than other asset classes. As you age and approach retirement, you would have more of your holdings in bonds that are usually more stable. Resources such as the three-fund portfolio give guidance on setting up this simple system.