Long-term investors with a well-diversified portfolio are more likely to achieve their financial goals than people who chase "hot tips" or try to time the market.
The caveat for this statement is the investor must have a regular investment program, choose great stocks, be willing to cut losses and a strategy to buy stocks based on a thorough analysis of the company.
Many people with retirement plans (401(k) and such) meet most of these requirements. Investors who choose individual stocks, as opposed to or in addition to mutual funds must work harder to diversify their portfolios.
Time is an investor's best friend (or worst enemy if you wait too long) because it gives compounding time to work its magic. Compounding is the mathematical process where interest on your money in turn earns interest and is added to your principal.
Consider the following totally unrealistic example of four investors ages 25 - 55. Each invests $2,000 per year and earns 8%.
At age 65:
- The investor who started at age 25 has over $585,000
- The investor who started at age 35 has just $250,000
- The investor who started at age 45 has just $98,800
- The investor who started at age 55 has just $30,700
The results are quite dramatic and, as you might expect, the youngest investor comes out the best. However, look at the difference starting 10 years sooner can make. The fewer years invested the more dramatic the difference with the next youngest age.
The investor who starts at age 45 still earns over three times as much as the investor who starts at age 55. Of course, part of the difference is the 45-year-old investor has 10 years ($20,000) more to invest, but the rest of the difference is the power of compounding.
No one expects to earn 8% each and every year. Some years you will earn less, some years you will lose money and some years you will hit a home run. However, the example is still a valid look at why long-term investing makes sense.
Since we can't go back to age 25 and start over. Let's look at the power of long-term investing from a different goal. What will it take for each of these investors to accumulate $750,000 at age 65, assuming they all earn 8% and ignoring inflation and taxes?
- The investor who started at age 25 needs to invest $213 per month
- The investor who started at age 35 needs to invest $500 per month
- The investor who started at age 45 needs to invest $1,650 per month
- The investor who started at age 55 needs to invest $4,072 per month
While all four investors reach the goal of $750,000, it is obvious that the younger investors get a lot more "heavy lifting" from their investments. The lesson is clear: The earlier you start the less you have to invest to reach your goal.
Correcting for Problems
The examples above describe the mathematical advantage of starting early, however they don't represent a "real world" situation. It is highly unlikely that you could achieve a constant return of 8% over a long period.
The investor with a long-term perspective can also correct for mistakes along the way. For example, that stock you thought was going to soar like an eagle turned out to be a turkey. If you have a long-term perspective, you can change investments that aren't working for other alternatives. However, if you will need the money from your investment in the near future (fewer than 5-7 years), a mistaken investment can create real problems in meeting your goals.
Long-term investors, especially those who invest in a diversified portfolio, can ride out down markets like the one that began in 2007 better than others who try figure out when to get in and when to get out of the market (timing the market)
However, for the investor just starting out at age 55, a market downturn can be disastrous. There is no room for error with only 10 years left before retirement at age 65. This investor will need to begin moving assets into more secure and stable investments such as high-quality bonds and blue chip stocks.
The reality of investing is that the market will go up and the market will go down. Investors that begin early and stay in the market have a much better chance of riding out the bad times and capitalizing on the periods when the market is rising.