This article was originally published on Fool.com. All figures quoted in US dollars unless otherwise stated.
There are dozens of investing strategies you can dive into as an individual investor. You can invest in growth stocks or dividend stocks or index funds. You can diversify with cryptocurrencies. You might use options or a real estate mortgage to add leverage.
But there's one overall investing strategy that works extremely well for individual investors: taking a long-term view. Making an investment decision through the lens of what it will look like 5, 10, or 20 years out leads to fantastic results for most investors. Here are the advantages of thinking long term.
You get time to be right
Trying to predict where a stock price will be a year from now is really difficult. There may be dozens of professional Wall Street analysts following any individual company and providing their predictions about where the stock price will be a year from now. Two highly intelligent professionals can have drastically different answers for where they think the stock price will be in a year, and they're often both wrong.
A stock price is frequently influenced by factors beyond the control of management, and it may not reflect the operations of the company. If a global pandemic breaks out, for example, the entire stock market may decline.
Over the long run, however, winners start to emerge. A good company's stock will outperform its peers. Investing in these companies will pay off, but it could take a while.
Historically, the U.S. stock market has delivered very strong returns, but it's had spells of much lower than expected returns too. In fact, you could've done better investing in alternative assets like money market accounts or bonds during some stretches in the market. The longer you stay invested, though, the more likely U.S. stocks are to outperform other asset classes.
See the following table for the rolling-period returns of the S&P 500 (adjusted for inflation) and how it compares to the returns of bonds.
| Metric | 5 Years | 10 Years | 20 Years |
|---|---|---|---|
| Lowest CAGR | (13.2%) | (5.9%) | (0.2%) |
| Highest CAGR | 33.4% | 20.0% | 13.6% |
| Average CAGR | 7.2% | 6.9% | 6.6% |
| % of periods outperforming bonds | 72.5% | 85.6% | 98.1% |
Data source: Robert Shiller. CAGR = compound annual growth rate.
The longer you stay invested, the more likely you are to generate a positive real return and outperform bonds. A long-term horizon gives you more time to be right, even if you're wrong in the short run.
Take bigger bets
Using a long-term investing strategy also allows you to take bigger bets on companies sharing your long-term vision. A company may invest heavily in research and development and scaling its business, and it might burn cash for many years before its efforts pay off with meaningful earnings.
Amazon (NASDAQ: AMZN) is a prime example (pun intended) of a company that makes long-term bets that negatively affect its operating income in the short term. But the bets it's made have paid off extremely well, cementing its dominant position in online retail by littering the country with fulfilment centers while building a market-leading cloud computing platform and the third-largest digital advertising business in the U.S. These bets required significant investments with extended time horizons -- it's only in the past few years that Amazon has generated meaningful operating profits.
If you're confident in management's ability to take big bets and cut losses when they fail -- as with the Fire Phone -- you can easily withstand the short-term ups and downs of growth stocks with great long-term potential.
Lower your tax burden
Maintaining a long-term outlook also allows you to keep your tax burden low. If and when you need to sell a stock -- because it no longer fits your thesis, you need to rebalance, or to liquidate holdings -- you'll likely be able to take long-term capital gains. Long-term capital gains receive a favorable tax rate, usually 15% for most people, versus short-term gains, which are taxed at your marginal income tax rate.
Not only that, but you'll also be able to plan your taxes more effectively. You may take capital gains at the most opportune time, filling up the 0% tax bracket. You may be able to harvest capital losses and offset your gains. There are lots of tax strategies you can take advantage of when you maintain a long-term outlook.
Keeping your tax burden low ensures you keep more of your capital invested, instead of cutting a big check to the IRS every year. The more capital you can keep invested, the bigger your portfolio will grow over time, because not only are you saving money on taxes every year, that money compounds along with your other investments.
If you maintain a long-term outlook, you'll have more patience for investments that you believe will eventually outperform. Ultimately, that's the best path to grow your money like magic.
This article was originally published on Fool.com. All figures quoted in US dollars unless otherwise stated.
