To answer the question of the best way to invest your money for the long-term, it’s necessary to first define the two terms, “long-term” and “invest.” First, in the world of investing, the long-term is generally considered 7-10 years or longer (as opposed to the short-term of three years or less and the intermediate term, which is in between the two). Additionally, the word investing is often misused and confused with terms like speculating or day-trading, which are entirely different, far riskier strategies. Generally speaking, investing is considered a buy-and-hold strategy that takes advantage of the historical precedent whereby assets generally rise in value over time. On the other hand, both speculating and day-trading try to take advantage of timing issues and/or extremely short-term trends or fluctuations in prices. An oft-used phrase that helps underscore the difference between investing and speculating is that “time in the market (i.e. investing) is more important than timing the market (i.e speculating).”
Interplay between risk and return
In addition to understanding the definitions of terms when writing about investing, we must also understand the importance of risk and its role in investing. Risk is essentially the variation in investment returns. Numerous academic studies as well as historical observation have shown that investment risk becomes lower the longer you are invested. In other words, your chances of having more money than you began with at the end of your investment period increases as the investment period increases (i.e. the variation in investment returns diminishes over time). For example, consider investing $1,000 in Microsoft for one day. On any given day, Microsoft’s stock may be up or down. As a result, you may end up with more or less than $1,000 after that one day. However, if you were to invest $1,000 in Microsoft and not sell it for 30 years, you would have a much better chance of having more than $1,000 after that 30 year period than you did after the one day period.
It is also important to understand that risk and return in investing are inversely related. In other words, the only reasonable way to expect to earn greater investment returns is to assume greater investment risk. Generally, this is accomplished through the different types of assets in which you invest. Without getting into the details of the why and how, the list below offers various investments assets ranked from least risky (cash) to most risky (international small cap stocks):
2. Short-term gov’t
2a. Short-term corporate bonds
2b. Short-term junk bonds
3. Intermediate-term gov’t bonds
3a. Intermediate-term corporate bonds
3b. Intermediate-term junk bonds
4. Long-term gov’t bonds
4a. Long-term corporate bonds
4b. Long-term junk bonds
5. REITs (Real Estate Investment Trusts)
6. Large cap domestic stocks
7. Mid-cap domestic stocks
8. Small cap domestic stocks
9. International (developed market) large cap stocks
10. International (developed market) small cap stocks
11. Emerging market stocks
These are your traditional investment assets. In addition to these there are many other assets available such as commodities, real estate, private equity, hedge funds, and many, many others. Most of these non-traditional assets will fall outside the purview of long-term investing (see investing vs. speculation above), although a well constructed, diversified portfolio of ample size should consist of non-traditional as well as traditional assets. Generally, the non-traditional assets, especially private equity, hedge funds and real estate, require much larger outlays of cash than do traditional investments. As a result, these types of non-traditional investments are out of reach for most investors.
The final question to ask yourself about investing for the long-term is what is your risk tolerance. How comfortable (or capable) are you with shouldering short-term price fluctuations in your investments. Keep in mind when answering this question that we are referring only to long-term investing. This is generally for retirement or your children’s education. Investing for other purposes may not be considered long-term depending upon when you need the money. The importance of the investment time-horizon cannot be overemphasized in the decision of how to invest your money.
As mentioned earlier, investment returns tend to increase with the assumption of additional investment risk. If you have a very long period of time (i.e. 30 years or so) then I would suggest an investment strategy that includes mostly risky assets as noted in the list above. These assets have the greatest potential for investment returns and their relative risk diminishes significantly over time. As your time horizon gets shorter and closer to the 7-10 year threshold, I would advise adding some of the lower risk assets like large cap stocks and intermediate term bonds. Ultimately, the goal is to construct a well-diversified portfolio that consists of a variety of assets, each of which will perform independently under differing market conditions. Unfortunately, this isn’t very easy as many of the assets in the list above tend to perform similarly to one another in certain circumstances.
Diversification is an important concept to understand. Consider an example: if you had put 100 percent of your money in Microsoft 30 years ago to invest for the long-term you would not have been very diversified. Of course, you would probably be very rich right now since Microsoft’s stock has performed outrageously well over the last 30 years. On the other hand, if you had invested 100% of your assets in Enron 30 years ago, you would be broke right now because Enron went bankrupt a few years back. Therefore, diversification can hurt you in that it can reduce returns on high performing assets like Microsoft. However, diversification is very necessary because you must protect yourself from the possibility that the one (or few) asset(s) in which you choose to invest could perform poorly (or even go bankrupt).
To avoid this problem you will generally want to own about 30 assets within each asset class. In other words, Microsoft and Enron are (or were at one time) both considered large cap stocks and as such were members of the same asset class. Owning them both may slightly reduce your risk (versus owning just one of the two) because Microsoft is a technology company whereas Enron was an energy company. Hence, there prices will largely be impacted by different variables. Therefore, while one stock alone may have wide swinging price fluctuations over the short and long-term the combined return of the two stocks taken together should have less variation. Furthermore, the more stocks you add to this portfolio, especially from multiple different industries exposed to multiple different factors, the more diversified and less risky the overall portfolio taken as a whole will become. This technique is known as diversifying within an asset class.
In addition to diversifying within an asset class, it is also common to diversify your money across different asset classes (i.e. stocks, bonds, cash, etc.). However, this is less important for a long-term strategy because as we have already addressed, risk reduces greatly over time and the relative risks amongst the different asset classes become much smaller over a long period of time. As such, it is safe in my opinion to have a long-term investment strategy that consists of 100 percent stocks if the investment period is long enough. Even a period as little as 7-10 years probably only requires about 30 percent or less in bonds.
The best and easiest way to diversify is through the use of mutual funds (or separate account managers for portfolios of sufficient size – probably greater than $5 million). Mutual funds themselves are typically diversified within an asset class because they generally own 30 or more assets within one asset class. Therefore, if you want to diversify your portfolio it is best to do this by buying one mutual fund in each asset class to which you want exposure based upon your risk tolerance and time-horizon. I recommend index funds as opposed to actively managed funds because index funds tend to have lower fees and less tax impact than their activelty managed counterparts (more on this below).
Limiting the impact of both taxes and fees on returns
A final note about the impact of taxes and transaction costs on investing for the long-term. Taxes and transaction costs are the easiest way to control your long-term returns; after all, you won’t have any control over what the markets will do. Over a 30-year period, a one percent reduction in returns as a result of transaction costs or management fees will have a dramatic impact on your results. Consider the difference between earning nine percent per year vs. 10 percent per year over 30 years. If you invested $10,000, after 30 years you would have an additional $41,800 if you earned 10 percent per year than you would if you had only earned nine percent per year. And taxes, because they can take a huge bite out of your returns, can have an even greater impact on your long-term investing results.
There are two really good and easy ways to simultaneously reduce both taxes and transactions costs and fees. The first is to buy-and-hold and not generate a lot of transactions. Obviously, if you are not generating a transaction you will not be charged a transaction fee. In addition, any time you sell an investment asset at a gain, you must pay a capital gain tax on that gain of up to 35 percent based on current tax law (the actual tax will depend upon both your tax bracket and how long you have owned the asset). If you do not sell the asset there is no gain. Therefore, reducing transactions will reduce both taxes and fees.
The second valuable tool for reducing taxes and fees is investing in index funds. Index funds are designed to mimic the returns of an index (such as the S&P 500). Nowadays, there are literally hundreds (if not thousands) of different index funds to choose from. The benefit of index funds is that they are not actively managed by a team of portfolio managers and analysts. Therefore, their fees tend to be much lower than actively managed funds of the same asset class. In addition, because the funds try to mimic the index, and because the index itself does not dramatically change very often, the index fund will have very few transactions in turn resulting in very low taxes.
Finally, many mutual funds contain something called “loads.” A load is essentially a commission that your broker earns for selling you the mutual fund. However, nowadays there are many great index funds that have no loads. These funds are called “no-load” index funds. If you are paying a load you are throwing away money unnecessarily. Some of these loads can be as high as 5% or more of your initial investment. Insist upon buying only no-load funds. Both Vanguard and Fidelity as well as others have a good choice of no-load index funds to choose from. You can also consider buying exchange traded funds (ETFs), which are index funds that trade like stocks as opposed to being traded like mutual funds.