3 Benefits of Long-Term Investing

Portfolio Planning Article

Charles Schwab & Co., Inc.

Call us at 866-232-9890

Send us an email

Printer-friendly
Type Size: A A A
Email to a friend

3 Benefits of Long-Term Investing
by Bryan Olson, CFA, Vice President, Head of Portfolio Consulting, Charles Schwab & Co., Inc.
September 25, 2006

Imagine a cross-country car race that starts in downtown Manhattan during rush hour. One racer sees bicycle messengers speeding by in the stop-and-go traffic. Becoming impatient, he jumps out of his car, trading it for a bicycle. Once out of Manhattan, as other racers still in their cars pass him, he quickly realizes his short-term decision was unwise in light of his long-term goal of winning the race.

It may seem rather silly for this racer to trade in his car for a bike, yet investors do the same thing every day. They lose sight of the strategy that it will take to get their prize. Although many investors claim to understand the benefits of long-term investing, their actions often show a short-term focus.

So, what is long-term investing? And why is it a tenet of Schwab's investing philosophy?

Long-term investing is being committed to a sound investment plan—one that starts with a proper asset allocation appropriate to your risk tolerance—over a length of time, such as five to 20 years.

More importantly, though, long-term investing is a mindset that gives you perspective and discipline as you work toward your financial goals—and can keep you from making costly mistakes based on short-term perceptions. Here's how it works:

Benefit 1: Maximize your wealth
The wealth you can accumulate over your lifetime is determined by three factors:

The amount you save and invest
The return you earn on your investments
How long your money compounds (i.e. generating earnings from previous earnings)

The long-term mindset is key to this last point: how long your money compounds from reinvesting your investment earnings. This is something most investors have direct control over. The earlier you start and maintain the long-term outlook, the more time compounding has to work its magic.

Albert Einstein referred to compound interest as the greatest mathematical discovery of all time. And Ben Franklin stated, "Money makes money. And the money that money makes, makes money." How true!

Don't forget, you may not need as much time as you think to make a real difference. Long-term may not be as long as you think. Using a convenient rule of thumb: dividing 72 by your rate of return tells you roughly how many years it will take to double your money. For example, earning 8% a year doubles your portfolio in just nine years (72÷8 = 9).

Benefit 2: Prevent costly mistakes
Losing sight of the long term and thinking you can time the market by exiting at the peak and re-entering the market at the trough over the short term is a big mistake. Timing market shifts correctly is nearly impossible, although making modest adjustments to your strategic allocation based on current market analysis can add value. However, we continue to see investors making wholesale market timing bets.

Not investing when you have investable funds can be another form of market timing. By staying out of the market, an investor is assuming they can predict the market's near-term results. This is usually based on the recent past, which can be very misleading.

Why can market timing be so costly? Because returns are often concentrated in short periods. For example, in January 2006 small cap stocks were up 9%. More than half of the month's gain came in the first six days of trading.

We studied portfolios to see what happens when you miss the top days in the market. Our research, looking at returns from 1996-2005 shows that missing the market's top 10 days cut the return by more than half on a portfolio of stocks, represented by the S&P 500®.

Missing a few trading days can hurt
S&P 500®, 1996-2005¹

Source: Schwab Center for Investment Research® with data from Ibbotson Associates, Inc.

Missing the top 20 days dropped the return below even T-bills. And missing the top 30 days—that's 30 days out of 10 years, fewer than 2% of the trading days—produced a negative return. You can see how a small number of trading days can equate to large differences in return.

Benefit 3: Lower your risk
Having a long-term mindset and lengthening the time you hold investments can often reduce the probability of experiencing negative returns.

We studied the highest return, lowest return and average annual return of the S&P 500 over various holding periods from 1926. We found that as you move from a one-year holding period to a three-year, 10-year, and finally to a 20-year holding period, the number of negative returns experienced goes down. In fact, there's never been a 20-year period with a negative return.

The longer you hold an investment, the less chance of experiencing a negative return
Range of S&P 500 returns, 1926-2005²

Source: Schwab Center for Investment Research® with data from Ibbotson Associates, Inc.

Stay focused
How can you keep your long-term state of mind the next time you're tempted by a short-term decision?

Remember that keeping a long-term state of mind doesn't mean ignoring your portfolio. It means developing a plan based on long-term expectations, not short-term trends. Along the way there will undoubtedly be some fine-tuning. Investing for the long-term can help maximize wealth, prevent costly mistakes and lower the downside risk in your portfolio.

Or, to quote legendary investor Warren Buffet: "Someone is sitting in the shade today because someone planted a tree a long time ago."

1. Data is annualized based on an average of 252 trading days within a calendar year. The year begins on the first trading day of January and ends on the last trading day of December and daily total return index closing levels were used for the period 1996 through 2005. Total return includes reinvestment of dividends.

2. Every one-, three-, five-, 10- and 20-year rolling calendar period for the S&P 500 Index was studied from 1926 through 2005, using annual total return data and rolling forward in annual increments. The highest and lowest annualized returns for the specified rolling time periods were chosen to depict the volatility of the market. Total return includes reinvestment of dividends.

Indexes are unmanaged, do not incur fees or expenses, and cannot be invested in directly.

Past performance is no indication of future results.

The Schwab Center for Investment Research is a division of Charles Schwab & Co., Inc.

The information presented does not consider your particular investment objectives or financial situation and does not make personalized recommendations. This information should not be construed as an offer to sell or a solicitation of an offer to buy any security. The investment strategies and the securities shown may not be suitable for you. We believe the information provided is reliable, but Charles Schwab & Co., Inc. ("Schwab") and its affiliates do not guarantee its accuracy, timeliness, or completeness. Any opinions expressed herein are subject to change without notice.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The type of securities mentioned may not be suitable for everyone. Each investor needs to review a security transaction for his or her own particular situation. Data contained here is obtained from what are considered reliable sources; however, its accuracy, completeness or reliability cannot be guaranteed.

(0906-7338)

Return to Top

Schwab can help

Get a diversified investment portfolio.