Regular readers of this blog would be aware of my unwavering commitment to adopting a long-term perspective when it comes to making financial decisions. While I firmly believe in this approach, I also recognise that there are occasions when short-term decision-making can offer advantages. Nevertheless, it’s important to note that such instances are infrequent and exceptional.
Why does a long-term focus produce superior results?
Adopting a long-term approach with financial decisions offers two primary advantages.
Firstly, it encourages a focus on long-term fundamentals because you must be fixated on selecting an investment that will deliver above-average returns over the next 10+ years. This long-term perspective helps filter out unhelpful, short-term noise.
Secondly, a long-term approach minimises risk and reduces costs. It’s lower risk because you just need to make the initial decision correctly and then have the patience to wait for the investment returns (compounding capital growth) to materialise. Additionally, it is less costly as you avoid incurring taxes and fees with each sale of an investment.
In contrast, for short-term investment decisions to yield superior returns, one must accurately decide what to invest in today, sell that investment for a profit in a few months or years’ time, and reinvest the proceeds in another equally attractive opportunity after paying any taxes. You need to be consistently correct with each investment decision. There is no room for error if you are to produce better returns.
It’s impossible to beat compounding returns.
The chart below illustrates the equity generated by an investment initially worth $1.5 million over a 30-year period, assuming an average capital growth rate of 7% p.a. The equity growth is divided into 5-year increments.
Over the initial five years, the asset experiences a growth in value exceeding $600,000, equating to an annual increase of over $120,000. Subsequently, during the fifth 5-year span (spanning years 21 to 25), the investment appreciates in value by $2.3 million. This translates to an annual growth of more than $460,000 in future dollars, equivalent to nearly $270,000 in today’s dollars when adjusted for inflation. All you must do is buy now and wait 20 years.
I’m sure you agree that it is very difficult to identify several short-term investments that generate this level of pre-tax investment returns.
Short-term returns might provide instant gratification, but…
Banking a relatively quick profit feels like making financial progress—it’s a quick sugar hit. However, the above basic analysis demonstrates that there is a huge opportunity cost associated with chasing instant gratification.
In the long run, you’ll never beat the power of compounding capital growth that a smart long-term strategy delivers. The sooner you begin that long-term journey, the closer you are to enjoying the returns.
When might a short-term focus be necessary?
When starting out, individuals may find it necessary to concentrate on generating short-term returns to enhance their financial position.
As an example, I have previously written about a steppingstone strategy which involves the acquisition of a property in a secondary location, completing a renovation, and leveraging the gained equity to purchase a longer-term home in a desired location. However, it’s crucial to acknowledge that in this scenario, if the market takes an unfavourable turn, the strategy can seamlessly transition into a medium-term approach by holding onto the property until market conditions improve.
In essence, I believe there are very few situations where a purely short-term strategy makes sense.
Addiction to short-term decision-making
A short-term strategy aims to secure a profit within a relatively brief holding period. This may involve actions like purchasing a stock with the intention of selling it in a few months or investing in a property in a speculative location.
The risk of adopting this approach is that you can become accustomed to short-term decision-making. You may consistently seek immediate gains while delaying the commencement of the long-term investment journey, incurring significant opportunity costs, as demonstrated in the chart above. The longer you adopt a short-term approach, the more addicted you become to it.
Furthermore, it’s important to note that a single poor short-term investment can ruin the whole strategy. One mistake (poor investment) can wipe out all your past returns.
Set a deadline
If you find yourself drawn towards a short-term investment for any reason, it’s crucial to establish a clear deadline for transitioning to a long-term approach. Initiating your long-term investment journey at the earliest opportunity will bring you closer to enjoying the power of compounding returns.
Short-term investments cost you time.
The two main necessary ingredients required for a successful investment strategy are (1) quality assets and (2) time. The one thing that is irreplaceable is time. As such, investors must be very careful to avoid wasting time following an inferior investment approach.
“The big money is not in the buying and selling, but in the waiting.”
Charlie Munger, Vice Chairman of Berkshire Hathaway
