What Long-Term Investing Truly Is
“Only buy something that you'd be perfectly happy to hold if the market shut down for 10 years.” –Warren Buffett
Every investor should understand that longtime investing is not the same as long-term investing. The former simply entails buying and selling assets over several years. Meanwhile, the latter requires you to buy, hold and maintain selected assets through thick and thin.
Plenty of investors find themselves unintentionally conflicted between the two.
In a 2014 study by AssetMark, Inc., a consultant for financial advisers, 95% of mass affluent investors said they are invested in the market for the long term. However, 58% of those investors also expect their advisers to frequently change their investments based on market conditions.
You are either a short-term investor or a long-term investor; you cannot be both. Trying to walk a middle road between the two can be disastrous to your portfolio. Ensuring that you are a true long-term investor takes a sensible perspective and focus.
Part of the conflict between short- and long-term investing may originate from an unrealistic expectation of risk and return. As economist Harry Markowitz revealed in his groundbreaking 1952 paper introducing modern portfolio theory, risk and return are related. Essentially, high risk is expected to be rewarded with a high return and low risk is expected to generate a low return.
Therefore, a low risk and high return investment doesn't exist. Further, you cannot attempt to manage risk like a long-term investor while jumping to different assets to try and capture recent high returns.
A harder challenge to overcome is a behavioral bias to focus on the immediate over the prolonged. We typically make decisions based on current values rather than an overall strategy. That is, it’s easier to follow the daily fluctuations of stocks and bonds and harder to concentrate on the bigger picture of growing your portfolio for retirement over many years.
Our intuition can cause us to narrowly focus on gains and losses rather than wealth. We are just better wired to make quick, rash decisions with information at hand. It’s fight or flight. Our ancestors couldn't both pummel a charging saber-toothed tiger while fleeing to the safety of a cave.
But yet, that's what some investors, as evidenced in the study above, try to do with their portfolios. This graph from the Investment Company Institute 2014 Fact Book shows just how much investors focus on gains and losses as new cash flow to stock funds is correlated to recent returns:
Chart: Investment Company Institute. 2014. 2014 Investment Company Fact Book: A Review of Trends and Activity in the Investment Company Industry. Washington, DC: Investment Company Institute. Available at www.icifactbook.org.
In other words, investors are chasing returns, or short-term investing. Such behavior has been shown as a losing proposition compared to long-term investing. The Federal Reserve Bank of St. Louis compared the performance of a return-chasing portfolio against a buy-and-hold portfolio. Over a five-year period, it found the buy-and-hold portfolio outperformed by 2% over a five-year period. The results would have been greater over an even longer time period.
This is a strong case for investing in an asset allocation with an expected return to meet your needs, at a risk level you are comfortable with, so that you stick with your portfolio for the long term.
Of course, long-term investing doesn't mean doing nothing all of the time. As gains and losses inevitably shift your asset allocation, periodic portfolio rebalancing can help return it back to its original target levels.
Being a long-term investor means knowing what matters is where you are at in the end, not the gains and losses along the way. Remember, as an investor you are providing capital to major companies and governments from around the world that should, over time, give you back more. The market can fall, but it historically has always bounced back.
Therefore, long-term investing isn't valuing the means – the market – but where you are in the end – your goals. As humans and investors we are only capable of focusing on one thing, and you have to choose. Do you want to narrowly track everyday market fluctuations or your grand goals on the horizon? If you have chosen the latter, then you truly are a long-term investor.