Financial literature usually waxes eloquent about long-term investing. From the likes of the Oracle of Omaha to the mutual fund portfolio manager, most investors will tell you that wealth can truly grow only if it is invested for the long-term. More often than not, a long term investment strategy has a higher probability of maximizing one’s return over a period of time compared to competing alternatives. From an investor’s perspective, long-term is usually considered as an investment period that exceeds 5 years. A long-term investment strategy offers myriad benefits to an investor. Two of the most compelling ones are discussed below.
Mitigate the impact of volatility
The benefits of long-term investing lend themselves very well to equity investments. In the short-term, equity investments are prone to witness enhanced volatility due to the noise created by the behavioural biases of investors. This leads to sharp and often irrational movements in stock prices that can inadvertently increase portfolio volatility and overall portfolio risk. Since most investors do not have an appetite for risk or do not know the best way to deal with volatility, they tend to stay away from equity investments. However, it is important to understand that while stock prices might respond to short-term noise, over the long-term, the true fundamental value of a stock is expected to emerge. Thus, long-term investing can smoothen the impact of the ebbs and flows of the markets and help investors reap the true potential of their equity investments. Additionally, companies can trade below their intrinsic value for short periods of time as stock prices respond to the various economic and business cycles. However, over the long-term, once a company has weathered multiple cycles and reached a stable state, it is assumed that the stock price will reflect its true intrinsic value. A long-term investment strategy for equities can potentially help investors reduce portfolio volatility and enhance risk adjusted returns.
Harness the power of compounding
When you choose to invest for the long-term, you give your investments an opportunity to harness the power of compounding. Dubbed by Einstein as the 8th wonder of the world, compounding is one of the biggest benefits of long-term investing. The compounding process ensures that an investment has two sources of returns: 1) returns generated on the original invested principal amount and 2) returns generated on the earnings that are reinvested.
Simply put, compounding is a mathematical process through which an asset’s earnings, from either capital gains or interest, are reinvested to generate additional earnings over time.
Let us understand this better with an example: An investor invests INR 1,00,000 in equities today. After a year, the equity investments generate a return of 10%. Thus, at the end of the year, the investment would have grown to INR 1,10,000. At this juncture, the investor chooses to continue with the equity investment instead of exiting his position. Now, the next year, the investments generate another 10%. Since he decided to continue with this investment, the investor earns 10% on the original INR 1,00,000 that he had invested and 10% on the INR 10,000 that he had earned at the end of year 1 and chosen to reinvest it. Thus, he earns 10% of INR 1,10,000 thereby, growing his investment value to INR 1,21,000. Over a period, this process will lead to both his principal and interest income multiplying.
It is quite challenging and risky to time the market. Some might even say that trying to time the market is a futile exercise. Additionally, when confronted with enhanced volatility or falling markets, investors often exhibit sub-optimal investment behaviour which is driven by behavioural biases rather than knowledge and logic. However, by staying invested for the long-term, investors can mitigate the impact of all these external influences. Historically as well, it has been observed that stock markets generate good returns over the long-term, reflecting the overall growth and productivity of the economy.