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 why should this be? Wouldn’t it be better to try and exit the market ahead of a downturn, and buy before asset prices rise again?

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 and a long-term view means that investors should not feel obliged to sell just after a significant dip in markets, but should wait until they 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 good idea in theory, but it doesn’t tend to work in practice. This is because it goes against human nature – and even the most experienced investors find this a challenge.

Following the herd

Investors tend to follow the herd, selling at times when markets are bad and buying when everything is rosy. This is borne out by the annual study by US market research firm Dalbar, whose most recent edition, for 2018, indicates that the average investor underperformed the S&P 500 in both good times and bad. In October, a bad month for the market, the average investor’s return was 1.13% lower than the index, while in August, a strong month, the average investor’s portfolio underperformed by 1.46%.

Dalbar chief marketing officer Cory Clark says: “Judging by the cash flows we saw, investors sensed danger in the markets and decreased their exposure, but not nearly enough to prevent serious losses. Unfortunately, the problem was compounded by being out of the market during the recovery months.”

Fear and greed generally lead investors to make emotional rather than logical decisions. Successful market timing requires two correct decisions: when to get out and when to get back in. Statistically, guessing right once is a 50% probability game while guessing right twice is only at 25%. Consistently repeating this pattern can lead to long-lasting detrimental 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 gains, and the chance to recover the value of their investments. Buying when the market appears to be in turmoil is just too painful. Taking a long-term perspective can help avoid these pitfalls inherent in market timing.

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 to enable dividends to roll up and gains to be reinvested.

Analysis from Fidelity demonstrates how powerful the impact of reinvesting dividends from investments can be. Someone who had invested £100 a month in the FTSE All Share index over the past 30 years and reinvested all the dividends would today have a portfolio worth £130,140. Taking the income would have left a portfolio of just £66,069 – barely half as much.

Costs matter, too – every euro paid in charges eats into future returns. Here the magic compounding effect works in reverse – the impact of costs 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 keep costs low.

It is easy to be swayed by the noise of market news, buying and selling on the basis of each Donald Trump Tweet or economic statistic, 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 and rational in the long term. In general, holding periods are getting ever shorter, with the average for the largest ETF tracking the stock market just 12 days. This creates an opportunity for those 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 long term, and panicking over short-term market fluctuations is only a distraction. In reality, a bit of stock market volatility isn’t 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 would want 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 a level of risk that is not necessary.

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

“Investing is a problem that has been solved. Keep it simple, hold down costs, diversify, invest for the long run, let the magic of compounding work for you. Statistically speaking for most investors, this is a high-probability solution” – Dave Nadig (ETF.com)