This is part #2 of a five-part series on Investing the Rational Way. Read part #1 here.
Rational Rule #2: Think Long-Term
Ok. You’ve got your stocks, bonds, mutual funds, etc. Now you need to follow every stock you own on a minute-by-minute basis and make sure you buy low and sell high constantly for the next 50 years.
Done.
You’re now a millionaire.
Not quite.
Once you invest, especially in mutual funds or index funds, I always recommend letting the money sit. And sit. And sit. Check your portfolio every five to ten years. Then reallocate based on your status in life and your goals.
Smart investing is a waiting game. The ultimate waiting game.
It takes time – think decades, not years – for compounding to do its thing.
But there’s another reason to take the long view.
In the short-term, investment returns fluctuate. The price of a stock might be $90 per share one day and $85 per share the next. And a week later, the price could soar to $120 per share. Bond prices fluctuate slightly overtime. And yes, even the returns you earn on your savings account change with time. (High-interest savings accounts yielded five percent annually in the U.S. just a few years ago; today, the best savings accounts yield about 1.5%.) Ben Bernanke kept us down for a while.
Short-term returns aren’t an accurate indicator of long-term performance. What a stock or fund did last year doesn’t tell you much about what it’ll do during the next decade. Don’t try to predict the future or go with your gut. Check out what Warren Buffet recommends and read the story of his million dollar bet on the S&P 500.
Check out this historical performance of several types of investments.
The research showed that, for the period between 1926 and 2006 (when he wrote the book):
- Stocks produced an average real return (or after-inflation return) of 6.8% per year.
- Long-term government bonds produced an average real return of 2.4%.
- Gold produced an average real return of 1.2%.
Real Estate returns are even worse. A study covering the period 1952-2005 found that when costs and imputed rental income were included, the real return to homeowners was 6.9 percent, comparable to the 7.3 percent real return for the S&P 500.
Although stocks tend to provide handsome returns over the long-term, they come with a lot of risk in the short-term. From day-to-day, the price of any given stock can rise or fall sharply. Some days, the price of many stocks will rise or fall sharply at the same time, causing wild movement in entire stock-market indexes. Check out Enron if you don’t believe me. Heck, even Facebook lost billions in value recently.
Even over one-year time spans, the stock market is volatile. While the average stock-market return over the past 80 years was about 10% (about 7% after inflation), the actual return in any given year can be much higher or lower. In 2008, U.S. stocks dropped 37%; in 2013, they jumped over 32%. Despite the stock market’s ongoing wins, the average person almost always underperforms the market as a whole. Even investment professionals tend to underperform the market.
During the 20-year period ending in 2012, the S&P 500 returned an average 8.21%. The average investor in stock-market mutual funds only earned 4.25%. Why? Because they tended to panic and sell when prices dropped, and then bought back in as prices rose – just the opposite of the “buy low, sell high” advice we’ve all heard.
Investing is a game of years, not months.
Don’t let wild market movements make you nervous. And don’t let them make you irrationally exuberant either. What your investments did this year is far less important than what they’ll do over the next decade (or two, or three). Don’t let one year panic you, and don’t chase after the latest hot investments. Stick to your long-term plan.
Stay Rational
-B&T