Given the daily and sometimes extreme fluctuations in the stock market, it takes an investor with both nerve and patience to build and maintain a long-term portfolio.
There are many people who run towards stock investment as a way to make some quick money. This is perhaps not the best investment option for people with short-term rewards in mind. The best option when thinking of investing in stocks is if you are interested in accumulating funds over a long period of time.
Both short- and long-term stock investments come with risks attached, and nothing is truly guaranteed. Today could be very good and tomorrow very bad, resulting in great gains or great losses.
In the short term, the market is very risky and many people are making the mistake that they think they can beat the market, that is, buy low and sell high. But market timing is easier said than done because you have to get your timing right not once but twice, by buying at the right time and also selling at the right time.
So what is considered short-term? Many people are under the misconception that short-term means less than a year, but this is not so. For stocks, short-term is considered five years or less, and some experts will recommend even more than five years. A good rule is that if you are going to need your money in five years, then you need to have a properly diversified portfolio where your short-term financial needs are taken into consideration. Another point to note is that unless you are an active trader, short-term investments make no sense.
The math is just not in your favour if you invest on a short-term basis. If you lose 50 per cent in one year, it will be twice as hard to get even, because you will need a 100-per-cent return to break even.
The sub-prime crisis of 2008 offers a classic example. The SET Index went down by 50 per cent that year, but those long-term investors who did not panic and remained invested until 2010 would have got all their money back, because the market bounced back strongly – 100-per-cent return – in 2009 and 2010. Those continuing to follow dollar-cost average during market downturns would have made some profits too because their holding costs have been averaged down.
When investing in the stock market, there are two components to your return – the prospects of capital gain and dividend income. Many short-term investors forget about dividend income, which can make up as much as 50 per cent of your overall return.
According to Morningstar, dividends, which are distributions of a portion of company earnings to shareholders, accounted for 45 per cent of the S&P 500 Index’ total return since 1930. Dividend-oriented stocks can be a good source of income and help provide downside protection at the same time.
The benefits of long-term investment in the stock market are many. First, upside potential – stocks offer growth prospects most investors need to reach their goals. Second, downside-protection potential – dividends may help cushion the impact of market declines. Third, yield – generally dividends on the S&P 500 Index, averaging about 4.28 per cent from 1930-2010, offer higher yields than cash investments, which may provide a potential income boost but with additional risk.
Fourth, inflation hedge – rising dividends may be an effective approach to help offset inflation. The first oil crisis during the 1970s with runaway inflation is a classic example where investors had to rely heavily on dividend income in the United States, averaging about 4.26 per cent per year, for protection against inflation. Capital gains during that period were only 1.6 per cent.
Stock investment will offer many great opportunities, but can be distressing for a short-term investor. If you know that the money you are investing will be required for use in a short time, then choose investment options that are more secure and protected. It is true that you may get lucky and make a fortune, but it is also true that the risks are high and you could lose everything.
Vira-anong C Phutrakul is managing director of retail banking at Citibank.