No matter what your life goals may be, investing for the long term is an important component of any financial plan. Especially any financial plan that ends in financial freedom.
It’s a must for preparing for retirement and can also help you achieve other savings milestones further down the road. By avoiding the constant buying and selling of stocks (or mutual funds, ETFs, etc.), you’ll create a strategy that can truly earn 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 your risk while growing your wealth over time. During the last 100 years, the economy has certainly experienced ups and downs, as is expected throughout history. Yet since 1926, the S&P 500 has experienced an annualized average return of about 10%.
That shows exactly why long-term investing is so important. Riding out the downturns allows your investment portfolio to rebound and take advantage of the ensuing gains. And an average return of 10% demonstrates that there is certainly a strong chance that a portfolio of diversified investments will fare well over time.
Plus, consistently making contributions to your investment accounts allows you to take advantage of compounded gains. As your investments grow, the new value earns any future gains, creating a snowball effect that ideally gets bigger and bigger over time — even if you keep your contribution amount the same.
You can ride out periods of turbulence
With a long-term strategy in mind, you’re better able to remove your emotions from the decision-making process. That means when the economy tanks and you watch your portfolio value plummet, you don’t sell all 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 stocks when they’re low, you’ll end up paying more for them when you feel it’s “safe” — because the rebound has already started.
A great example of this was the 2020 crash from the economic ramifications of the COVID-19 pandemic. Between December 2019 and March 2020, the U.S. equity market fell 20%. By July 2020, however, it had already reached (and soon surpassed) those pre-crash levels. Investors who sold stocks in March lost out on one of the fastest recoveries in U.S. history. An investor with a long-term investment strategy would likely have weathered the storm while coming out ahead.
Dollar-cost averaging balances out short-term fluctuations
Even when there’s not a stock market crash, stock prices do experience short-term fluctuations. If you were to save up your cash and invest in one lump sum each year, you would be limited to whatever the price was on that day.
Instead, a better strategy is to consistently invest that amount throughout the year. This is called dollar-cost averaging. Ride out the minor fluctuations that occur regularly — some days you’ll pay lower prices, and some days you’ll pay more. In a bear market, you can also use this strategy to “buy the dips,” which means you buy up 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 may already do this if you invest in a 401(k) at work and have contributions deducted straight from your paycheck. Or you can set up recurring contributions with your own brokerage or robo-advisor account.
Rather than trying to time the market, dollar-cost averaging allows you to spread out your investments over time at various price points.
You’ll pay less in capital gains tax
The amount you owe for capital gains tax varies based on how long you owned a stock before you sold it. The short-term capital gains tax rate is used on assets that you held for less than a year. They are taxed at your usual income tax rate.
But anything you held 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 could be 0%, 15%, or 20%. Standard IRS income tax rates, on the other hand, range anywhere from 10% to 37%.
So if you earn $60,000 and buy and sell stocks within a few months, any money you made would be hit with a 22% tax rate. But if you held those stocks for a year or longer, you’d only be taxed at a 15% tax rate.
Let’s say your gains were $1,000. The short-term capital gains tax would cost you $220, while the long-term capital gains tax would only be $150.
That’s a big difference that should sway you towards a long-term investing strategy.
You’ll pay fewer trading fees
Buying and selling stocks typically results in a trade commission. If you try to manage day trading rather than a long-term strategy, you could easily eat up your profits with trading fees.
Some online platforms have made it possible to trade without incurring any fees, but there are still plenty of brokerages that charge you for each and every trade. These fees typically range between $1 and $5.
Remember to include those costs into your strategy with each trade you make, or stick to long-term trading to keep them at a minimum.
You’ll spend less time than day trading
Short-term investing takes a lot of time and effort, and you’re still not guaranteed a profit. Long-term investments don’t offer any guarantees either, but you can leave a lot of room in your schedule by not constantly monitoring your investments in an attempt to time your trade.
You can certainly DIY your long-term portfolio, but there are also other options to make it even easier. You can:
- Hire a financial advisor.
- Automate the process with a robo-advisor.
- Purchase a fund focused on your target time horizon.
Then your portfolio is calibrated as needed to remain diversified and on track to meet your goals. Plus, that extra diversification lowers your risk level because you’re not relying on just a handful of investments.
Use retirement accounts for savings on income tax
Retirement savings should be part of your long-term investing strategy, and there are different options available to help lower your income tax bill. Both a 401(k) and a traditional IRA let you invest money through your plan without paying any income taxes on the contributions for the year. When it comes time to withdraw funds during retirement, that money is taxed at whatever income rate you’re at for the year.
A Roth IRA lets you invest with taxed income this year, then avoid paying taxes when you make withdrawals in retirement. Both types of tax-advantaged accounts only work if you wait to make withdrawals when you’re at least 59½ years old. If you were to simply keep a taxable income account with a short-term mindset, you’d end up paying a lot more in taxes than using a long-term retirement account.
When long-term investing works best
Long-term investing is best for funds you plan to use well in the future.
Retirement planning for 20 or more years from now is one of the best examples of when to opt for a long-term strategy. Another scenario is when you start having children. Investing in a college savings plan is a great way to save for their higher education. Plus, most plans adjust your assets based on how close college is — as it approaches, your funds are shifted to less volatile investments.
Long-term investing is not designed for short-term savings goals, like a wedding or down payment for a house. That cash should be put into 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 to employ, here are some tips to help you get started.
Define your time horizon
Your investments should have a purpose other than to grow as much as possible. Explicitly define your financial goals so you can assign each one a time investment horizon. Example goals include your kids’ college tuition, retirement, or buying real estate.
Once you know the amount of time you have until you need the money, you can choose the best investments. For shorter timelines, go with investments that have less risk. If you have a longer period of time (such as decades before you retire), you can invest in riskier stocks that have greater potential for growth.
Diversify your portfolio
It’s important to diversify your long-term portfolio. If a certain company or industry faces problems and loses value, your entire portfolio won’t tank. Typically, experts recommend a mix of stocks and bonds. But the ratio depends on your time horizon, since stocks are much more volatile.
You can also diversify based on the size of companies, the scale of growth, and the price-to-earnings ratio.
Long-term investing is all about removing emotions from the decision-making process. Rather than focus on short-term market volatility, you can feel confident in your time horizon and that the power of compounding earnings should ultimately help you reach your goals.
Check your fees
There are a lot of fees involved with investing, even if you’re holding onto your investments for the long term. First, make sure your financial advisor (or robo-advisor) fees are competitive. Otherwise, they’ll eat away at your returns year after year. And if you invest in mutual funds and exchange-traded funds (ETFs), you’ll pay an annual expense ratio.
This helps to cover the administrative costs of running the fund. Compare prices to make sure you’re not overpaying, especially if there’s a comparable option that’s less expensive.
Schedule consistent review sessions
It’s important to keep an eye on your portfolio and make adjustments to keep your asset allocation balanced. Choose a timeframe that makes you most comfortable, such as quarterly or annually. If one asset class has grown substantially, you’re likely over-invested in it from a risk perspective. At this point, you would want to shift some of the inflated asset class to a lower risk class, based on your pre-determined asset allocation.
This, of course, is only for DIY investors. If you use a financial advisor or automated robo-advisor, they should perform the rebalancing on your behalf. But it’s still smart to check on your portfolio on a regular basis even if you’re not the one actively managing it.
Investing always comes with an element of risk. But you can mitigate that risk while also taking advantage of time in the market by investing with a long-term strategy. Plus, you’ll end up saving money on taxes, giving your investments even more time to grow. Give yourself distinct goals with specific time horizons to help you develop a plan for the future. Trust us, you’ll thank yourself later.