Having a long-term time horizon can help you avoid making poor short-term investment decisions. A multi-year time horizon can also give you an advantage toward achieving superior returns by allowing you to make high-potential investments that others with a shorter timeframe would avoid. This article will elaborate on why being a long-term investor can help you achieve better returns, and illustrate how you can go about doing so.
Long-term investors are less common than you might think
I was a young associate at one of the biggest investment firms in the world. It was a typical evening in the middle of December, when many of us were working late. Another associate and I were discussing how he liked the prospects of a certain industry based on his long-term outlook when a recently-promoted portfolio manager walked in. He asked my colleague if he had any stocks that he could recommend. The other associate began to tell him about the group of companies whose long-term prospects he was just telling me about, but the portfolio manager cut him off, “I am so close to beating my benchmark this year. So close. I need something that will work by year-end.” There was a silence during which I looked at the portfolio manager and waited for an indication that this was his attempt at late-evening humor. There wasn’t any.
Why to be a long-term investor
- Investing for the long-term allows you to take advantage of high return opportunities that others might shun. Consider an investment that is expected to result in a 15% annualized rate of return over 5 years, but for which the first 4 years are expected to be negative, with all of the returns coming in year 5. Quite a few investors, including many professionals, would pass on that investment. For professionals, this could be due to a misalignment of incentives, which may push them towards a shorter-term time horizon lest they lose their jobs or their clients while they wait for returns. For individuals, it could be due to the desire for instant gratification. Remember the marshmallow test that young children were subjected to in order to see how long they would forego eating one marshmallow in order to get two later? The behavior observed in those children opting for instant gratification is unfortunately frequently still present in adults making financial decisions.
- Being a long-term investor helps guard against behavioral biases. In my article on behavioral defense, Behavioral Defense in Decision Making, I wrote about the recency bias which causes people to over-extrapolate the near-past further into the future more than the facts merit. Taking the long-term view on an investment should cause you to think about more than just what has been happening recently in order to arrive at a reasonable conclusion, potentially lessening the impact of this bias.
- Long-term investing reduces frictional costs, such as trading expenses and tax impact. There is a dramatic difference in after-tax returns for a taxable investor with a holding period of many years compared to one whose gross returns are due to short-term gains. Over a 20 or 30 year period, that difference could translate into several percent of after-tax return per year. This difference is enough to cause someone who follows a long-term investing approach to retire years earlier than a person who is saving the same amount and achieving the same pre-tax returns, but doing so through short-term trading.
- Evidence shows that longer holding periods are associated with better performance.
- According to data from Dimensional Fund Advisors, over the 15 year period ending on 12/31/2015 the average holding period of a stock by U.S. equity mutual funds has been approximately one year.
- The data presented above shows that when equity funds were divided into quartiles based on their average holding period, a much higher percentage of funds with longer holding periods outperformed the benchmark over the full period than did funds in any of the other quartiles.
- The quartile of funds with the longest average holding period had an average holding period over 3.5 years and 29% of those funds outperformed their benchmark. This frequency of outperformance is almost twice as high as the 17% for all funds in the study, and more than three times as high as the 8% for the quartile of funds with the shortest holding period which averaged less than 6 months.
- All quartiles had the majority of the funds underperforming their benchmark over this 15-year period, a finding consistent with my recent article, Why Passive Investing is an Excellent Default Choice – an Active Investor’s View.
How to be a long-term investor
- Never put yourself in a position to be a forced seller. Price volatility only matters if you are forced to sell when prices are low. If you don’t have to sell (or even better, if you can arrange your circumstances so that you can deploy capital when assets are priced unreasonably cheaply), then price volatility is not going to hurt your long-term financial outcome. The best way to put yourself in this position is by matching the time when you will require funds to the type of investments that you make. For example, equities and other long-duration assets are not appropriate for those who will likely need a substantial portion of their investment within 3, and preferably 5, years in the future. So if you anticipate needing a large portion of your capital in the next few years, consider investing the amount that you will need in the short-term in lower return and lower volatility assets such as cash or short-term government bonds. This can give you the staying power to invest the rest of your assets appropriately for the long-term.
- Ignore news, opinions and commentary that is not likely to matter in 5 years. Specifically, be sure to ignore broad general fears about how a geopolitical or macroeconomic event is sure to affect prices in the short-term. There is no better way to ensure you are likely to do the exact opposite of what you should be doing than by getting caught up in the emotional rollercoaster of news reports and opinions about where the market will be at the end of the year. (Hint: nobody really knows where the market is headed in the short-term, but some find it entertaining to speculate nonetheless.)
- Avoid the principal/agent problem and misalignment of incentives. If you invest directly, then this isn’t a cause for concern, and your challenge is to overcome various behavioral biases and pressures. However, if you invest through an agent (e.g. a financial advisor or a fund manager), then make sure their incentives are aligned with long-term value creation on your behalf. Rest assured that if their compensation or job security depends on their short-term investment results, they are unlikely to act with a long-term time horizon which is most likely to benefit you.
Few individuals or professionals are truly able to take the long view. There are too many behavioral and incentive-related pressures to do otherwise. However, the rewards for being able to follow a disciplined investing strategy focused on the long-term are likely to be meaningful for those who are able to do so.