With a 20-year investment perspective, you are considered to be a long-term investor. Put your money in the stock market, directly or through mutual funds containing stocks; the value of your investment may fluctuate, but over a longer time span, your average return is higher than what safer options can offer.
Your stock or investment fund may be up 11% one year, down 6% the next, then rebound up 9% and so forth, so it's definitely a bumpier ride than safe and predictable options, such as a savings account or a certificate of deposit (CD). However, when the 20 years have passed, you are virtually guaranteed to come out ahead in terms of actual dollars in your account.
Safety comes at a price, while risk gets you a premium. Since you don't have to lose sleep over a stock market crash in a particular year, you get to reap the premium while the long-time span negates most of the risk.
- A long-term investor has a minimum of a 20-year time horizon; this time frame enables them to avoid playing it safe and to instead take measured risks, which can ultimately pay off in the long run.
- Dollar-cost averaging is a smart strategy for long-term investors as it involves investing a set amount at regular times, often monthly, regardless of market performance or the strength of the economy.
- Buying stocks and funds that provide dividends is another good technique for a long-term investor to use, as is automatically reinvesting those dividends.
- Compounding is a huge advantage for a long-term investor, with an asset's earnings reinvested to garner bigger earnings over time.
With dollar-cost averaging, an investor sets aside a fixed amount at regular intervals, regardless of other circumstances. A classic example of this would be a 401(k). Dollar-cost averaging is a technique often employed by long-term investors.
If you invest a certain amount every month, you are buying shares in good times as well as bad times. In good times, the value of your shares increase. For example, suppose you start buying shares in a stock fund that cost $20 per share. You decide you will invest $100 every month. So that means you get five shares for your $100. A year later, the fund has done well and the share price has risen to $25. Now you only get four shares for your $100, but you're happy anyway; the five shares from that first month a year ago have appreciated in value, 5 x $25 = $125, netting a $25 gain. The second month, the shares were $21, so that month you got 4.77 shares, netting you a $19 gain, and so forth. In good times, you get fewer shares, which reduces the future potential upside, but it also means you have a nice total gain on your investment.
Suppose the share price had dropped from $20 to $15 in that first year. You'd have made a loss of 5 x $5 = $25 on your first month's investment. The second month you bought shares at $19 apiece, meaning you got 5.26 shares. The loss from the second month then becomes 5.26 x $4 = $21, and so on.
While that loss certainly stings, you are getting shares at a discount to the initial purchasing price, ultimately getting more shares for your monthly $100 investment. Since the share price is only $15, you can snap up 6.67 shares per month for as long as the slump lasts. When things brighten up six months later, you have purchased 6 x 6.67 = 40 shares at what might have been the bottom. Then, even with a modest rebound to $18 a share, you have now made a gain of 40 x $3 = $120 from those bargain shares alone. Meanwhile, the loss from the first month has shrunk to $10, the second month to just over $5 and so on, meaning you are already back in the black with a vengeance. When the share price returns to the original $20, the initial loss is completely wiped out, while the gain of the six months' bargain shares grows to 6 x $5 = $200.
If you keep your cool and stick with the plan even when the market is down, you get more shares for your money. These additional shares boost investment returns when the market rebounds. This is a big part of the reason why regular stock investors get a higher long-term return compared to safer investments despite the temporary ups and downs in the market.
Many stocks and funds also give dividends to investors. The dividends are essentially profits given to the owners (shareholders) providing a couple of extra percent return on top of regular share price increases. Most mutual funds and stocks offer the option of automatically reinvesting the dividends. This is done in good times as well as bad times, meaning that you get dollar-cost averaging on what is essentially an invisible boost to your regular investment schedule.
With compounding, an asset's earnings are reinvested to garner more earnings; the profits occur as the investment is generating earnings from the original dollar amount and the built-up earnings from the previous periods.
Assume that you have decided to invest in a mutual fund with an average annual return of 7%, including the dividend. For simplicity's sake, assume that compounding takes place once a year. After 20 years, you will have paid 20 x 12 x $100 = $24,000 into the fund. However, the compounding return will more than double your investment. The easy way to run the numbers is using a calculator, but you can do the math manually by adding the new year's contribution to the old total and then multiply the new total by 1.07 for each year.
Year 1: $1,200×1.07=$1,284
Year 2: ($1,284+$1,200)×1.07=$2,658
Year 3: ($2,658+$1,200)×1.07=$4,128
As the amount you have to invest grows over time, the variety of options for investing you have expands, enabling you to have an even more diversified portfolio.
In reality, your annual statement won't be as tidy as any calculator can predict. For starters, the math is usually heavily simplified in that it does not take into account any of the fees, taxes and similar factors. There's also some wiggle room in how it calculates the averages going into the equation. Still, history shows consistently superior returns for regular investing in stocks or stock funds compared to other types of investments, making it the obvious choice for a long-term investor.
A small sum such as $100 leaves little choice besides mutual funds or ETFs, at least in the beginning. Many brokers charge a transaction fee when buying stocks; unless you're dabbling in the risky penny stock barrel, that means you won't be able to diversify your portfolio. By contrast, mutual funds are premade portfolios of many different stocks with a clearly defined risk profile and built-in diversification.
However, the mutual fund charges an annual fee that can grow to a rather substantial size as your capital grows. If you are comfortable taking a more active role in selecting your investments, it may make sense to pull the money out of the fund after a few years and create your own diversified stock portfolio at a discount brokerage.