3 Benefits of Long-Term Investing

November 21, 2012

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 they can take to help get to 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 allocation¹ appropriate to your risk tolerance—over a period of time, that can typically range from 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:

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, 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. Here's 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).

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 March 2009, US stocks were up 9%. Nearly 90% of the month's recovery came in just eight trading days following the low point of the stock market.

We studied portfolios to see what happens when you miss the top days in the market. Our research, looking at returns from 1992-2011 shows that missing the market's top 10 days cut the return by nearly half on a portfolio of stocks, represented by the S&P 500® index.

Source: Schwab Center for Financial Research with data from Standard and Poor's. Past performance is no indication of future results.

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 1992 through 2011. Total return includes reinvestment of dividends.

Missing the top 20 days dropped the return below even Treasury bills (T-bills). And missing the top 40 days—that's 40 days out of 20 years, fewer than 1% 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.

Having a long-term mindset and lengthening the time you hold investments can often help 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.

Range of S&P 500 returns, 1926-2011

Source: Schwab Center for Financial Research with data from Morningstar, Inc. Past performance is no indication of future results.

Every one-, three-, five-, 10- and 20-year rolling calendar period for the S&P 500 Index was studied from 1926 through 2011, 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.

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."