Monday, November 18, 2013

Long Term Investing and Compounding Interest


Advantages of Long Term Investing and Compounding Interest

There are generally two types of investors- those who attempt to time the market, predict stock prices, and make money quickly; and those who build long-term, diversified portfolios based on solid companies. There are many advantages of long term investing of which short term investors will miss.

One of the biggest advantages of long term investing is that while you may not be able to predict the market accurately in the short term, in the long term it is much easier. The history of the market, while allowing for short term dips and corrections, has historically gone up over time. By investing and holding on to stocks for longer periods of time, the chances of having growth is much greater.

Another advantage of long term investing when compared to short term, is cost. Each time an investor buys or sells a stock, there is a cost involved with regard to commissions and transaction fees. Long term investors, by definition, make fewer trades, and therefore incur fewer costs. Short term investors can easily rack up large trade costs when making frequent trades. Each time cost is incurred, profits are lost.

A third advantage of long term investing is with regard to taxation. For any account that is not a tax-sheltered account, such as IRA's, profits are subject to taxation. Profits in the stock market are subject to capital gains taxes. For short term investors, if a stock has been owned for less than a year, the capital gains taxes are equivalent to the person's regular tax bracket for the year. That may be as high as 35%. For long term investors, however, the advantage of holding a stock for a long period means that there is no taxation until the profits are realized; and once the stock has been sold, as long as it has been held for over a year, the profits are subject to a long-term capital gains tax, which is either 10 or 15%, depending on the investor's tax bracket.

A final distinct advantage of long term investing is the effect of compounding. Because many stocks, particularly the type often purchased for holding in long term portfolios, pay dividends, compounding is a great advantage for long term portfolio growth. As savvy investors know, compounding means not only do you earn interest on your money, you earn interest on your interest.

For stockholders, that translates to earning dividends in addition to capital appreciation. They can either accumulate dividend payments into interest paying accounts, or simply reinvest the dividends back into the stock, ending up with more shares and more dividends.

There are numerous advantages to long term investing. The last, and possibly most important to some investors, is the reduced risk that is incurred with the purchase of stocks for the long term. While short term buyers may lose money quickly, by holding on to quality companies for long periods of time, the risk of losing money is greatly reduced.

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