When it comes to successful investing, everyone is trying to figure out the ultimate secret. Regardless of whether you're a large private equity firm or an individual investor, chances are you want to know how best to invest.
This process can prove very challenging, especially because there are a lot of factors that you can't control in investing. You can't control whether a worldwide pandemic will hit, whether a company will suddenly have a lawsuit filed against it, or whether a huge economic event will happen. With all of these uncontrollable factors, investing can seem like a task nobody can manage.
Though it's true that there are a lot of things out of the everyday investor's control, there is one factor that affects invest returns more than anything else: time. Time smooths out a lot of volatility and is what allows the magic of compounding to occur.
Here's how you can take advantage of the most critical component of investing and stay invested for the long run.
Why Time is the Greatest Factor to Investing Success
Before getting into the details of how you can use time to your advantage, it's important to understand why time is such a critical component of investing.
Time Smooths Out Volatility
The biggest hindrance to most investors' success is volatility. It's easy to stay invested when things are going well, but as soon as the markets take a hit, lots of investors pull out and sell their holdings at a loss.
One of the main reasons why time is key to successful investing is because time smooths out volatility. For example, a study ran by Bloomberg and S&P (below) shows the chance that the S&P 500 produces a negative return. This is using historical time periods and, as you can see, the chance of a negative return decreases substantially as the holding period increases.
At a one year holding period, the chance of a negative return is 27% (still quite high). However, with a holding period of ten years, the chance drops down all the way to 6%. At a holding period of 20 years, the percentage chance is so close to zero that it's almost impossible for you to lose money over that time frame.
So, as you can see, a one year holding period can still prove very volatile, but as your holding period increases, so does the stability of your investment.
Time Can Correct Many Mistakes
When you invest in nearly any investment vehicles, at the end of the day you are purchasing a stake in the asset. As mentioned in the intro, there are many things that can go wrong in the world that can affect your asset. However, time can correct many mistakes.
For example, a private equity firm may buy a company and put in the wrong management team. This means that the executives at the company are not doing their jobs and causing the business to run inefficiently. In the short run, this can hit company performance quite hard and cause a lot of trouble for both the business and the private equity firm.
However, the private equity firm will undoubtedly get rid of the bad management company and recruit a better team. Given a long time horizon, this company has the potential to grow out of it's poor start. By the time the private equity company decides to sell the business, it is a well-oiled machine with a strong management team that has experience running the company.
If you were to try and invest in this business for the short term, you could have been caught up in the poor performance of the company and sold at a loss. You could never have predicted that the management team wouldn't work out, so your investment will have to suffer.
Long term investors don't face the same issue. They get to buy into the investment and then return years later to a successful return. When it comes to fixing bad products, changing services, or even replacing management teams, time is a company's biggest asset. Therefore, time is also an investor's greatest return amplifier.
Compounding Only Works Over Long Periods of Time
If you're involved in the investing space, it's likely you've heard something along the lines of “the general stock market has returned an average of 10% over the past hundred years.”
This statement is true, but it can also trick many people into expecting a 10% return every year. Some years the stock market takes a dive and people get scared: “where the heck is my 10% return??? This is a joke, I'm pulling my money out.”
The important thing to note is that the 10% average is exactly that… an average! If you zoom in to the general stock market returns for the past one hundred years on a yearly basis, you'll find that it's filled with immense volatility. Some of the worst years see the S&P500 drop downwards of -40%.
However, the longer your hold onto your investment, the higher the change that you achieve the 10% average historical returns for the stock market. This principle is true not only for stocks but for any investment. The magic of compounding only works if you give your investments time to compound.
Tips to Stay Invested for the Long Run
Investing for the long run is easier said than done. Here are some tips to help you take advantage of time for successful investing.
Control Your Emotions
Investing is as much about emotion as it is about the numbers behind the investments. One of the main keys to staying invested for the long run is to control your emotions.
One way to do this is to figure out your time horizon and remind yourself of it every once in a while. If you're not planning to liquidate your position for fifteen years, you have no reason to worry about whether or not the markets move up or down today.
Likewise, when everybody else is panicking and worrying that the world will end, you're shielded from their mania and can calmly go about your own life knowing that you don't need to worry about the markets for a long time.
Set Up Automatic Investing
One study done by Fidelity (one of the largest investment companies in the world) found that the best investors were either customers who were dead or completely inactive.
In other words, those who didn't tamper with their accounts and investments had the best returns in the long run. Though dying isn't really an option (for most people) and staying inactive means you can't contribute more capital, there is a way to continually invest with as little effort as possible: automatic investing.
Automatic investing works by taking a set amount of money from your account every month and putting it into investments. You can call up your brokerage and they can quickly set up automatic investing for you.
Once you have it set up, you don't even need to log into your account to invest. You don't need to worry about getting stressed over the way your portfolio is performing and give yourself a better chance of staying invested for the long run.
DON'T Follow the Markets
One of the worst things you can do for your psyche and investing potential is to consistently follow the markets every day and stress over how your portfolio is performing. One day, your emotions won't be able to take the pressure and you'll panic sell. This single move could cost you tons of money in the long run.
Once you have automatic investing set up, you don't need to worry about your investments anymore and actually SHOULDN'T actively stress over how the markets are performing. The further away you can stay from sensationalist headlines, the better your emotional control. Likewise, the better your emotional control, the longer you can stay invested.
Dollar Cost Average
Not letting your emotions take control of you is easier said than done. This is especially true if you've invested one large lump sum and don't contribute any more money. If the market takes a big dip, your entire portfolio will take a hit proportionate to the dip.
This is why dollar cost averaging into the markets can help you control your emotions and stay invested for the long term. If the markets take a sudden drop, you can rest assured knowing that you can scoop up more of the asset at a cheaper price.
Diversify Your Risk
Some people just can't stomach seeing their portfolio fall. They might say that they're alright seeing a huge hit to their portfolio, but when it actually happens, they panic and sell out.
If this sounds like you, consider diversifying your risk so that the downturns aren't so bad. If you're invested in stocks, this could mean taking some of your money and putting it into bonds. Historically, an 80/20 split of stocks and bonds has averaged a return of around 9% per year. This is almost as high as a pure stock portfolio, and the 80/20 portfolio holds up a lot better during a downturn.
You might sacrifice a little bit of compounding power by giving up a couple percentage points, but you'll be able to stay invested for longer and take better advantage of the power of time.
The Greatest Factor to Successful Investing
Everyone wants to know the secret to successful investing. Many people dedicate their entire lives to trying to figure out exactly how to beat the markets and produce above average returns.
The real key to successful investing is simply time. In the long run, those who stay invested for longer have a major advantage against those with a shorter investing time horizon. As the famous investing proverb goes: time in the market beats timing the market.
Jeff is a current Harvard student and author of the blog Financial Pupil who is passionate about learning, living, and sharing all things personal finance-related. He has experience working in the financial industry and enjoys the pursuit of financial freedom. Outside of blogging, he loves to cook, read, and golf in his spare time.