The growth power of a long-term approach to investment

Experts are fond of reminding us that investment should be for the long term. Anyone contemplating an investment in stock markets should be thinking over an investment period of at least five years. But wouldn’t it be better to try and exit the market ahead of a downturn, and buy in again before asset prices rise once more?

The argument for taking a long-term approach is that while stock markets tend to perform better than bonds and cash over long periods, they do not increase in a straight line. Stock markets can be volatile – as investors have rediscovered since the turbulence engendered by the Covid-19 pandemic. A long-term view means that investors should not feel obliged to sell just after a significant dip in stock prices, but should wait until markets recover – which they almost always do.

But wouldn’t it be tempting to try to time the market? Investors could sell up when they believe markets are likely to struggle, reinvesting when the outlook is more positive. This is a great idea in theory, but it very rarely works in practice. This is because it goes against human nature – and even the most experienced investors find this an almost insuperable challenge.

Following the herd

Investors tend to follow the herd, selling at times when markets are bad and buying when everything looks rosy again. This is borne out by the annual Quantitative Analysis of Investor Behavior study conducted by US market research firm Dalbar. Its most recent edition, for 2022, found that in a year when, unusually, both equity and bond markets lost ground simultaneously, the average investor lost even more.

The study found that investment losses coupled with increased need for cash prompted all types of US investor to withdraw funds from their investment accounts – especially bond fund and balanced fund investors. The bond fund market saw a bigger sell-off than in any year dating back to 1985, while funds with a mix of equity and fixed income securities experienced their highest net outflows since 1994. The average equity fund investor lost 21.17% of their account balance during the year, compared with 18.11% for the S&P 500 index.

Investors’ main concern should be making sure they are not adding to losses through an irrational attempt to avoid them.

Dalbar chief marketing officer Cory Clark says: “The reality is that markets will, about once every 10 years, experience a year like 2022 [but] that hasn’t stopped the markets from providing solid long-term returns to those patient enough to wait it out. It’s okay to sink a bit with the lowering tide because you’ll eventually rise back up with it. Investors’ main concern should be making sure they are not adding to losses through an irrational attempt to avoid them.”

The dangers of emotional decisions

Fear and greed are the most prevalent factors prompting investors to make emotional rather than logical decisions. Successful market timing requires two correct decisions: when to get out, and when to go back in. Statistically, guessing right once is a 50% probability, while the likelihood of guessing right twice is only 25%. Consistently repeating this pattern can result in long-term wealth destruction.

Being influenced by changes in the market or investment environment can be bad news for investors’ long-term returns. The strongest gains in the market often come immediately after a significant fall, or on specific days.

If investors sell at the first sign of trouble, they tend to miss out on the subsequent gains, and the opportunity to recover at least part of the value of their investments.

If investors sell at the first sign of trouble, they tend to miss out on the subsequent gains, and the opportunity to recover at least part of the value of their investments. Buying into a market that still appears to be in turmoil is too painful for most. Taking a long-term perspective can help avoid these pitfalls inherent in attempting to time the markets.

The magic of compounding

Compound interest (or other types of return) is one of the most important factors in generating long-term wealth. However, for it to work its magic, investors must leave their investments alone in order to roll up dividends and allow gains to be reinvested.

According to UK investment platform Hargreaves Lansdown, a £10,000 investment in the UK stock market at the end of May 1991 would have produced capital growth after 30 years to reach £33,416. However, reinvesting dividends over that period would have yielded an additional £62,576, taking the total in May 2021 to almost £96,000.

Costs matter, too – every euro, dollar or pound paid in charges eats into future returns. In this case the magic effect of compounding works in reverse – the impact of costs on the value of a portfolio increases over time. Buy-and-hold for the long term rather than trying to trade into and out of markets is the best way to avoid running up costly account charges.

It is easy to be swayed by the noise of market news, buying and selling on the basis of piece of economic data or angry exchanges between US and Chinese officials, but it adds trading costs, and will increasingly erode the real value of investments over time. When investors make changes to their portfolio, they need to be as certain as possible that the potential gains will outweigh the cost of trading.

Capitalising on irrationality

Stock markets tend to be irrational in the short term but rational in the long term. In general, investors’ holding periods are getting ever shorter; the average holding period for an individual stock in the US stood at 10 months in 2021, down from five years in the 1970s. This creates an opportunity for investors willing to be patient. Since prices do not always reflect a company’s real value, patient investors should be able to capitalise on this irrationality.

Many investors’ goals, such as retirement savings, university education for their children, or investment in a second home, are also geared to the longer term, so panicking over short-term market fluctuations is only a distraction. In reality, short-term stock market volatility is not likely to prevent investors achieving their ambitions if these are far enough in the future.

It is always worth asking yourself how much time you have to allow your investments to grow and how much money you wish to have at the end of the planned investment period.

It is always worth asking yourself how much time you have to allow your investments to grow and how much money you wish to have at the end of the planned investment period. The answers to these questions will provide a good guide to how much risk you can afford to take with your investments – although there’s no point in taking on more risk than is necessary.

Generally speaking, the longer your investment horizon, the better your returns are likely to be. While this doesn’t mean that individuals should simply make their investments and ignore them – you need to check that they remain on track to deliver on your long-term ambitions – it does mean that a hands-off, buy-and-hold strategy is usually the most profitable approach.