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Tuesday, April 19, 2011

Benefits of Long Term Investing

Like the fabled tortoise that beat the hare in the race, the investor who stays in for the long term is more likely to achieve his or her goals than the investor who chases “hot tips” for quick profits in the stock market.

Time is an investor’s best friend (or worst enemy if you wait too long) because it gives compounding time to work its magic. Compounding is the mathematical process where interest on your money in turn earns interest and is added to your principal.

Consider the following four investors ages 25 – 55. Each invests Rs 2,000 per year and earns 8%.

At age 65:

The investor who started at age 25 has over Rs. 585,000

The investor who started at age 35 has just Rs. 250,000

The investor who started at age 45 has just Rs. 98,800

The investor who started at age 55 has just Rs. 30,700

The results are quite dramatic and, as you might expect, the youngest investor comes out the best. However, look at the difference starting 10 years sooner can make. The fewer years invested the more dramatic the difference with the next youngest age. The investor who starts at age 45 still earns over three times as much as the investor who starts at age 55. Of course, part of the difference is the 45-year-old investor has 10 years (Rs. 20,000) more to invest, but the rest of the difference is the power of compounding.

This may not be the most “real life” example, since we can’t go back to age 25 and start over. Let’s look at the power of long-term investing from a different goal. What will it take for each of these investors to accumulate Rs 750,000 at age 65, assuming they all earn 8% and ignoring inflation and taxes?

The investor who started at age 25 needs to invest Rs 213 per month

The investor who started at age 35 needs to invest Rs 500 per month

The investor who started at age 45 needs to invest Rs 1,650 per month

The investor who started at age 55 needs to invest Rs 4,072 per month

While all four investors reach the goal of Rs 750,000, it is obvious that the younger investors get a lot more “heavy lifting” from their investments. The lesson is clear: The earlier you start the less you have to invest to reach your goal.

Problems & Corrections

The examples above describe the mathematical advantage of starting early, however they don’t represent a “real world” situation. It is highly unlikely that you could achieve a constant return of 8% over a long period. The reality is there will be times when your investments earn less and other times when you will lose money. There may also be times when you will earn more.

The investor with a long- term perspective can also correct for mistakes along the way. For example, that stock you thought was going to soar like an eagle turned out to be a turkey. If you have a long-term perspective, you can change investments that aren’t working for other alternatives. However, if you will need the money from your investment in the near future (fewer than 5-7 years), a mistaken investment can create real problems in meeting your goals.

Long-term investors, especially those who invest in a diversified portfolio, can ride out down markets like the one that began in March of 2000 without dramatically affecting his or her ability to reach their goals.

However, for the investor just starting out at age 55, a market downturn can be disastrous. There is no room for error with only 10 years left before retirement at age 65. The reality of investing is that the market will go up and the market will go down. Investors that begin early and stay in the market have a much better chance of riding out the bad times and capitalizing on the periods when the market is rising.