Whatever your life goals, long-term investing is an important component of any financial plan. Especially any financial plan that ends in financial freedom.
This is essential to prepare for retirement and can also help you reach other savings milestones in the future. By avoiding the constant buying and selling of stocks (or mutual funds, ETFs, etc.), you’ll create a strategy that can actually get you more in the long run.
Why long-term investing is a common winning strategy
When you’re ready to start investing, a long-term strategy is the most effective way to limit risk and increase your wealth over time. Over the past 100 years, the economy has certainly experienced ups and downs, as expected throughout history. However, since 1926 The S&P 500 showed an average annual return of about 10%.
This shows exactly why long-term investing is so important. Overcoming recessions allows your investment portfolio to recover and reap the profits. And an average return of 10% shows that there is certainly a good chance that a portfolio of diversified investments will deliver good results over time.
In addition, making constant contributions to your investment accounts allows you to earn cumulative returns. As your investment grows, the new value brings future returns, creating a snowball effect that ideally gets bigger and bigger over time, even if you keep your investment the same.
You can survive periods of turbulence
With a long-term strategy in mind, you’ll be better able to keep your emotions out of your decision-making process. This means that when the economy crashes and you watch the value of your portfolio plummet, you don’t sell all of your investments out of fear. Instead, you’ve already decided to stay the course; after all, turbulent periods are eventually followed by rebounds. And if you sell your stock when it gets cheaper, you will end up paying more for it when you feel it is “safe” because the rebound has already begun.
A great example of this was the 2020 crash caused by the economic fallout from the COVID-19 pandemic. Between December 2019 and March 2020, the US stock market fell by 20%. However, by July 2020, it had already reached (and soon surpassed) the pre-crisis level. Investors who sold stocks in March lost one of the fastest retracements in US history. An investor with a long-term investment strategy would likely weather the storm by coming out ahead.
More: Why You Shouldn’t Worry About the Stock Market Falling
Dollar cost averaging balances out short-term fluctuations
Even when there is no stock market crash, stock prices experience short-term fluctuations. If you were to save your money and invest one lump sum each year, you would be limited to the price that was on that day.
Instead, the best strategy is to consistently invest this amount throughout the year. This is called dollar cost averaging. Accept small fluctuations that happen regularly – some days you will pay a lower price, and some days you will pay a higher price. In a bear market, you can also use this strategy to “buy dip”, which means you buy more stocks while prices are low.
A great way to do this is to automate investments on a weekly, bi-weekly or monthly basis. You can already do this if you invest in a 401(k) at work and the contributions are deducted straight from your paycheck. Or, you can set up recurring contributions with your own brokerage account or robot advisor account.
Instead of trying to time the market, dollar cost averaging allows you to spread your investment over time in different price brackets.
More: Dollar Cost Averaging Explained — is this a smart way to invest?
You will pay less capital gains tax
The amount you have to pay capital gains tax depends on how long you owned the shares before you sold them. The short-term capital gains tax rate applies to assets you own for less than a year. They are taxed at the normal income tax rate.
But anything you own for more than a year is taxed at the long-term capital gains rate, which is lower. There are three different tax rates depending on your filing status and income level; it can be 0%, 15% or 20%. On the other hand, standard IRS income tax rates range from 10% to 37%.
So if you make $60,000 and buy and sell shares over the course of a few months, any money you earn will be taxed at a rate of 22%. But if you hold these shares for a year or longer, you will only be taxed at the rate of 15%.
Let’s say your profit was $1,000. The short term capital gains tax will cost you $220 and the long term capital gains tax will be only $150.
That’s a big difference and should sway you towards a long-term investment strategy.
More: Profits and Losses: What will be taxed and what can I claim?
You will pay less trading fees
Buying and selling shares usually results in a trading commission. If you try to manage day trading rather than a long term strategy, you can easily eat into your profits through trading fees.
Some online platforms allow you to trade without any commissions, but there are still many brokerage houses that charge a fee for each trade. These fees usually range from $1 to $5.
Remember to incorporate these costs into your strategy on every trade, or stick to long-term trading to keep them to a minimum.
You will spend less time than day trading
Short-term investing takes a lot of time and effort, and you’re still not guaranteed a return. Long-term investments also come with no guarantees, but you can leave a lot of room in your schedule if you don’t constantly monitor your investments in an attempt to time your trade.
You can certainly make your own long-term portfolio, but there are other options that will make it even easier. You can:
- Hire a financial advisor.
- Automate the process with a robot advisor.
- Buy a fund that targets your target time horizon.
Your portfolio is then calibrated as needed to stay diversified and on track to meet your goals. Also, this additional diversification reduces your risk level because you don’t rely on just a few investments.
Use retirement accounts to save on income tax
Retirement savings should be part of your long-term investment strategy, and there are various options available to help lower your income tax. Both a 401(k) and a traditional IRA allow you to invest money through your plan without paying any income taxes on your contributions for the year. When it comes time to withdraw funds during retirement, that money is taxed at any rate of income for the year.
A Roth IRA allows you to invest with taxable income this year and then pay no taxes when you withdraw money in retirement. Both types of tax-advantage accounts only work if you defer withdrawals when you are at least 59.5 years old. If you were just running a taxable income account with a short-term mindset, you would end up paying far more in taxes than you would with a long-term retirement account.
More: Beginner’s Guide to Retirement Savings
When long-term investing works best
Long-term investing is best for funds that you plan to use in the future.
Planning for retirement 20 years or more in advance is one of the best examples of when to choose a long-term strategy. Another scenario is when you start having children. Investing in a college savings plan is a great way to save money on higher education. Also, most plans adjust your assets based on how close the college is – as you get closer, your funds move into less volatile investments.
Long term investment is No intended for short-term savings purposes such as a wedding or a down payment on a house. This money should be invested in either low-risk investments or risk-free high-yield savings accounts.
5 tips for long-term investing
Now that you know why long-term investing is an important strategy, here are some tips to get you started.
Define your time horizon
Your investments must have a purpose different than to grow as much as possible. Clearly define your financial goals so that you can assign each an investment time horizon. Examples of goals include getting your kids into college, retiring, or buying real estate.
Once you know how much time you have before you need money, you can choose the best investments. For shorter timeframes, choose investments with less risk. If you have a longer period of time (for example, several decades before retirement), you can invest in riskier stocks that have more upside potential.
Diversify your portfolio
It is important to diversify your long-term portfolio. If a particular company or industry runs into trouble and loses value, your entire portfolio won’t collapse. As a rule, experts recommend a combination of stocks and bonds. But this ratio depends on your time horizon as stocks are much more volatile.
You can also diversify based on company size, scale of growth, and price-to-earnings ratio.
More: The 4-Step Guide to Diversifying Your Portfolio
Do not panic
Long term investing is everythingut removal of emotions from the decision-making process. Instead of focusing on short-term market volatility, you can be confident in your time horizon and that the power of accumulating profits should eventually help you achieve your goals.
Check your fees
There are many fees associated with investing, even if you hold your investment for a long time. First, make sure your financial advisor (or robo advisor) fees are competitive. Otherwise, they will eat into your income year after year. And if you invest in mutual funds and exchange-traded funds (ETFs), you will pay an annual expense ratio.
This helps cover the administrative costs of running the fund. Compare prices to make sure you’re not overpaying, especially if there’s a cheaper alternative.
Schedule Consecutive Review Sessions
It is important to monitor your portfolio and make adjustments to keep your asset allocation balanced. Choose the time period that works best for you, such as quarterly or yearly. If one asset class has risen significantly, you’ve probably overpriced it in terms of risk. At this point, you would like to move some of the overpriced asset class to a lower risk class based on a predetermined asset allocation.
This is, of course, only for DIY investors. If you use a financial advisor or an automated robo advisor, they must perform the rebalancing on your behalf. But it’s still wise to review your portfolio regularly, even if you’re not the one actively managing it.
Summary
Investments always involve an element of risk. But you can reduce this risk and also take advantage of time in the market by investing with a long-term strategy. Plus, you’ll end up saving money on taxes, giving your investment even more time to grow. Set clear goals with specific time horizons to help you develop a plan for the future. Trust us, you will thank yourself later.
