There are three reasons long-term holdings tend to outperform short-term trading, capital gains tax, and time value of money.
1️⃣ The capital gains tax is “a levy on the profit from an investment that is incurred when the investment is sold.” –Investopedia
2️⃣ The time value of money is “the concept that a sum of money is worth more now than the same sum will be at a future date due to its earnings potential in the interim.” –Investopedia
3️⃣ Compound gains: “Compounding is the process in which an asset’s earnings, from either capital gains or interest, are reinvested to generate additional earnings over time.” –Investopedia
As an investor, especially if you are young or new to investing, it’s important to remember that the longer you are in the market, the better your stocks will perform.
“Time in the market beats timing the market” – Unknown
This goes for trades made in taxed advantaged investing accounts like the securities held within a traditional IRA, Roth account, and your 401k; as well as, the stocks within recreational trading accounts. When you buy stocks and hold them for long periods, the stocks you buy the earliest tend to perform the best.
I love trading stocks and I love to make a quick profit, but if you were to hold on to a stock for 10 to 20 years, your results are generally going to be better than the returns that you get from holding a stock for a couple of days or months.
The Double and Triple Benefit of Compounding
Compounding has been called the 8th wonder of the world by Albert Einstein. Compounding can work against you in the form of interest on debt, and it can work for you in the form of compound gains and compound dividends.
Compounding is when your money (principle) makes money (interest) and then all of that your money (principle + interest) makes you more money. In the words of Lil Pump, that’s racks on racks on racks!
Compounding is how credit cards keep you in debt, but when used by an investor, compounding becomes a powerful tool for building wealth.
☀️ “The average credit card interest rate is 18.04% for new offers and 15.10% for existing accounts,” according to WalletHub’s Credit Card Landscape Report.
☀️ The national average interest rate for savings accounts is 0.06 percent, according to Bankrate’s Aug. 25, 2021, weekly survey of institutions.
☀️ “The Federal Open Market Committee (FOMC) judges that inflation of 2 percent over the longer run, as measured by the annual change in the price index for personal consumption expenditures, is most consistent with the Federal Reserve’s mandate for maximum employment and price stability.”
☀️ “The average annual return since adopting 500 stocks into the index in 1957 through 2018 is roughly 8%.” –Investopedia
☀️ The S&P 500 is an index that reflects trading in 500 of the stock market’s largest companies, and as a result is often used as a gauge for the broad stock market’s performance. In just under six decades leading up to 2013, the average dividend yield was 3.26 percent, according to a 2012 Forbes article.
As a long-term investor your 8% gains (on average), grow faster than a saver who receives 0.06% for parking their money in a bank account. Investors who gain an average of 8% a year also beat inflation which steals -2% of your purchasing power every year (on average).
What Does it all Mean?
When you compare those numbers, it’s easy to understand how the year-over-year gains of a long-term investor could easily outpace the gains a saver receives from bank interest even after subtracting -2% of those gains to account for the impact of inflation.
If the stock you invest in pays an average dividend, the long term investor can add another 3.26%, year-over-year to their potential gains.
My numbers are not perfect, but if you disregard the continuity issue caused by the random time period of the statistical data, which is a BIG unscientific IF, the long term investor would have gained 9.26% a year on average.
That 9.26% average return is the sum of an average 8% stock gain + an average 3.26% dividend yield – 2% losses from inflation. It’s important to note that, although the 9.26% return calculated in this article is calculated using facts, it’s important to remember that it is an unscientific, made up historic average.
It’s also important to note that “past performance is no indicator of future performance“. So In the real world, investors are just as likely to fall short of the average return on a bad year as they are likely to beat the average during a good year.
⚠️Warning: This is not investment advice.