Sep 30, 2024
Written by:
John McDowell
“Our favorite holding period is forever.” You can probably guess who said that. Yes, this famous quote is from Warren Buffet, one of the most successful investors of all times. Warren Buffet, Peter Lynch, Charlie Munger, and Benjamin Graham are some notable investors who advocate buying valuable stocks at cheap prices and holding them for the long term to generate returns and build wealth.
In this blog, we will delve into the power of long-term investing and explain how patience, disciplined strategies, and compounding returns can lead to substantial wealth accumulation. Additionally, we will cover essential principles such as the benefits of "time in the market" over "timing the market," the role of diversification, dollar-cost averaging, and the historical performance of major indices like the S&P 500. Finally, we will talk about some successful long-term investors and explain how their strategies can be applied by retail investors.
Long-term investing, or buy-and-hold investing, has stood the test of time and still continues to be one of the most recommended investing methods by investing gurus for building wealth. Different from swing trading and day trading, long-term investing is the complete opposite of being in and out of the market all the time. Instead, it requires an element of patience and trust that markets will rise eventually. Here are some of the most common long-term investing strategies:
Index funds allow investors to invest in equity indices cost-effectively. The fund is designed in such a way that the weights of individual stocks in the fund are similar to those in the index. By doing so, fund managers can replicate the returns of the index without actively managing the fund. This is what makes most index funds low-cost in comparison to other actively managed funds that aim to outperform the market returns.
For example, buying a unit of an S&P 500 index fund like the SPY exposes the unit holder to all the stocks constituting the S&P 500 index. Investing in index funds is one of the easiest and low-cost methods of growing wealth over time. When you buy an index fund, you effectively hold a share in the country’s economy, which is more likely to grow with time. This makes investment in index funds less riskier than investing in individual stocks, sector-specific, or other specialized funds.
Dividend-paying stocks are stocks of those companies that have a history of paying out sustained and/or growing dividends over decades. Investors can use dividend-yielding stocks for dividend investing, a strategy that involves reinvesting dividends to buy additional shares to compound their returns.
For dividend investing, a group of companies called dividend aristocrats, which have been increasing their dividend payouts consecutively for the past 25 years, might be considered a good investing option. Some notable companies in the dividend aristocrat category include Johnson & Johnson, Coca-Cola Company, Procter & Gamble Company, and Exxon Mobil Corporation. One way to gain exposure to a lot of these companies is through high dividend yield ETFs, like the Vanguard High Dividend Yield ETF symbol VYM. Much like investing in the SPY, this would give your portfolio exposure to a lot of dividend aristocrats.
Retirement accounts are another great way to build wealth in the long term. Most employers offer their employees either a 401(k) plan or a 403(b) plan, which are types of defined contribution plans. In defined contribution plans, both employers and employees make contributions to the retirement account, with limits to contributions set by the IRS.
These accounts are tax-advantaged and the funds deposited into the retirement account are invested in buying stocks, bonds, mutual funds, or a combination of these, depending on the risk profile, investment horizon, and age of the employee. Some employers offer their employees defined benefit plans, in which employees’ cash benefit at the time of retirement is calculated based on a predefined formula. The risks of investment underperformance are borne by the employer. Self-employed individuals can also benefit from tax-advantaged retirement accounts by opening an IRA (Individual Retirement Account).
Compounding is like a magical power that supercharges your investment returns. As Albert Einstein put it, "Compound interest is the eighth wonder of the world. He who understands it, earns it. He who doesn't, pays it.” Let’s discover how compounding works to accelerate your returns:
Compounding returns happen because of exponential growth instead of linear growth in the investment amount. Suppose you invest $1,000 that earns an interest rate of 10% compounded annually. After the first year, your investment would grow to $1,100. At the end of the second year, you would earn interest on $1,100 instead of your initial investment amount of $1,000, which results in exponential growth in your investment, growing your investment to $1,210, instead of $1,200 in the case of simple or linear interest.
If we let the interest compound for 20 years, your $1,000 investment would grow to $6,727 with compound interest versus just $3,000 in the case of simple interest. In short, with the help of compounding, your investment earned twice as much return than in the simple interest scenario.
The impact of compounding increases due to several factors, including the size of the investment, periodic additional investments, interest rate, periods of compounding, and the investment total holding period. So, if you want to leverage the power of compounding, you need to start investing early so that your investment can take more time to grow. Reinvest the interest and also make additional investments to snowball your investment size, which will magnify your return with each compounding period.
Buying an index fund is considered to be one of the best ways to invest in the stock market. That said, there are plenty of options available to investors, each providing exposure to different collections of stocks. Here are some of the top indices worth considering:
The S&P 500 index consists of stocks of the 500 largest publicly traded companies by market capitalization. The companies included in the index come from a range of different sectors, such as technology, healthcare, financials, etc. Investors who want to invest in all the constituent stocks of the S&P 500 index can simply buy any of the ETFs or mutual funds that track the index. The S&P 500 index is widely used as a benchmark to measure the performance of many investment products, the overall US economy, and the stock market.
The Nasdaq 100 index is composed of stocks of the 100 largest nonfinancial companies by market capitalization, listed on the NASDAQ stock exchange. Both the Nasdaq and the S&P 500 are the two widely-quoted indices in the US and are often used as benchmarks to gauge the performance of the stock exchange and the economy in general.
Various investment products like ETFs, mutual funds, and options contracts are available that mirror the returns of the Nasdaq 100 index. Nasdaq 100 is highly influenced by technology companies, which constitute more than half of its total market capitalization. Created in 1985, the Nasdaq 100 has outperformed the S&P 500 by a wide margin over the long term.
The MSCI World Index comprises large and mid-cap stocks from 23 developed countries, including the United States, United Kingdom, France, Japan, Germany, Canada, and Australia. The index is also widely used as a benchmark for various investments and represents the performance of the global stock market. The index is well-diversified and serves those investors well who want to diversify their investments and reduce their portfolio risk. To invest in the MSCI World Index, investors can purchase ETFs and mutual funds, such as Vanguard Total World Stock ETF (VT) and Schwab International Equity Fund (SWISX).
Diversification means reducing a portfolio’s volatility or risk by investing in different types of assets with low correlation. When assets in a portfolio have a low correlation with each other, it means that they won’t move in tandem, reducing fluctuations and wild swings in portfolio returns. Here are some common diversification strategies investors use:
Investing in different asset types, such as stocks, bonds, precious metals, and real estate, can help spread the portfolio’s risk into different asset types. Even if one of the asset classes performs poorly, the overall portfolio return won’t be impacted too much because of the presence of other asset types in the portfolio.
Investing in stocks from different sectors or industries can also contribute to diversifying a portfolio’s risk. The correlation between two companies operating in different sectors of the economy is mostly low, which makes inter-sector stock investments a plausible option for diversification. Index funds like the S&P 500 are one of the best investment vehicles that let you invest in stocks from almost every sector and industry.
Investing in stocks of different countries is another useful risk diversification method. For example, emerging economies like India, Brazil, and China are often associated with high growth, which is why many investors consider these markets a good investing opportunity, albeit with slightly higher risk. In contrast, investing in stocks of developed economies like the US, UK, Australia, Germany, etc. can provide stability but with low or average returns. There are many ETFs and mutual funds that allow investors to invest in emerging markets and foreign stocks.
Time in the market refers to the duration of the holding period from buying to selling an investment instrument in the market. In other words, time in the market determines how long an investor has remained invested in the market. Long-term investors employ a buy-and-hold investing strategy that focuses on finding good stocks or buying a low-cost index fund and holding it for long-term returns.
Timing the market, in contrast, refers to buying a security right at the moment when it is at its lowest while selling it at its highest point. Traders, who look to time the market, frequently get in and out of the market to buy low and sell high. However, this type of strategy is not only costly but risky as well. Opening and closing trades frequently incur commissions, fees, and slippages, which all add to traders’ expenses.
Traders who time the market have a motive to outperform the returns generated by the index. This is incredibly difficult to achieve, and research has shown that more than 90% of actively managed funds fail to outperform the index over the long term. A better alternative is the buy-and-hold strategy, which aims to replicate the returns of the market and ride out the temporary bumps without attempting to beat the market.
Dollar-cost averaging strategy is used to lower the average cost of your investments. It is a useful strategy for investors who want to invest periodically to build wealth over time. To employ this strategy, you need to decide the amount of money you want to invest periodically and the interval after which you want to invest that money.
Since the strategy aims to generate long-term returns and ignores temporary gyrations in the market, a temporary downfall in the market can reduce the average investment cost instead of dissuading you from investing. You just continue to make your investments irrespective of the market price and build the nest egg for achieving your long-term financial goals.
Building a long-term investment portfolio starts with assessing your current financial condition and determining your financial goals. The next step is determining your investment horizon, which is the number of years after which you will need the money. This will enable you to find out your risk profile. If you have a long investment horizon of more than 10 or 20 years, you can be aggressive with the risk and allocate a greater portion of your investment to stocks and potentially earn a higher return.
The key to building wealth is to leverage the power of compounding by saving and investing funds regularly for longer periods. So, it is necessary to create a budget and periodically set aside funds for investment.
Remember to build a diversified portfolio by including assets from different asset classes such as bonds, commodities, etc. If you are investing in stocks, consider buying an index fund like the S&P 500 or Nasdaq 100, which is a cost-effective way to invest in diversified stocks. Depending on your investment goals, you can allocate funds between bonds, stocks, real estate, and commodities accordingly.
If you want to save funds for your retirement, you can consider investing in tax-advantaged retirement accounts like 401(k), 403(b), IRAs, and Roth IRAs. Various options are available for self-employed as well as employed individuals.
Finally, it is essential to monitor the portfolio’s performance periodically and rebalance it if necessary to keep the returns on track to achieve your financial goals.
Since 1957 through Dec 31, 2023, the S&P 500 has generated an average annualized return of 10.32%. Adjusted for inflation, the annualized return during the same period drops to 6.47% per year. The cumulative return over the period was 72,048%, which means if you had invested $100 at the beginning of 1957, your investment would have grown to around $72,148.
There have been many events that have led to significant turmoils in the market, with the index dropping by as much as 50%. The dot-com crash in 2002, the global financial crisis in 2008, and the Covid-19 crash in 2020 were catastrophic events that sent the market crashing. However, the market has always recovered subsequently. This means that the longer the investment horizon, the higher will be the chance to generate positive returns and ride out those intermittent years of negative returns.
Let’s have a look at the investing strategies of some of the world’s most successful long-term investors and try to learn some lessons from them.
Buffet’s investing philosophy was centered around buying undervalued companies and holding them for the long term. His notable investments include Berkshire Hathaway, Coca-Cola, and American Express. Warren Buffet’s success teaches investors to focus on analyzing companies’ fundamentals rather than short-term stock movement and investing for the long term.
Peter Lynch’s investing philosophy was to identify companies with strong growth potential that are available at reasonable prices. Understanding the company’s business model is pivotal in spotting growth companies, which is the central point of Lynch’s investing philosophy. Like Warren Buffet, he also advocated holding the investments for the long term to realize their true potential. His notable investments include Dunkin' Donuts and Ford Motor Company.
Numerous other successful investors like Charlie Munger, John Templeton, and Jack Bogle have more or less similar investing philosophies that teach us important lessons like value investing, long-term investing, fundamental analysis, diversification, growth stocks, etc.
Long-term investing is a time-tested investing strategy that has changed the lives of many investors and turned them into billionaires. The key to long-term investing is to consider buying stocks as akin to buying a piece of a business. Don’t trade stocks for the sake of trading to realize small gains. Instead, hold them for the long term, just like you would own a business. Invest consistently at regular intervals and let the power of compounding amplify your returns. Even investing regularly in an index fund like the S&P 500 for the long term can earn you significant returns and help you build sizable wealth.
Tags: Investing
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