In financial markets there are two main types of characters in play, investors and speculators. They differ much from each other for the reason why they buy or sell financial assets and what they expect, in fact:
- Investors expect their profits in the stock market to come from the free cash flow generated by the underlying business, which eventually will be reflected in a higher share price or distributed as dividends, from an increase in priceof the shares that they hold in their portfolio and by a narrowing of the gap between the share price and the underlying value of the company. Their analysis are generally based on an evaluation of company fundamentals, by looking at the balance sheet and at other financial statements, they tend to have a medium/long-term time horizon;
- Speculators, on the other hand, buy and sell securities based on whether they believe those securities will rise or fall in price in the near future. Their analysis are not based on company fundamentals but on a prediction of the behaviour of other actors and therefore they tend to have a short-term time horizon.
As you may have noticed, one of the characteristics that can help us distinguish between an investor and a speculator is the time horizon adopted.
This is important to keep in mind because is not uncommon to see investors that, in certain cases, usually when fear or greed are involved, lose their long-term focus and tend to look more at the short term. Unfortunately this is not uncommon for investors, not only for novices but also for the most expert ones, and this is mainly caused by the general environment of financial markets that, from the news to analysts and brokers, tend to focus more on what is happening now and what they think will happen next week, next month or (if we are lucky) next quarter.
The combined effects of all these actors hit the emotions of the investor, by stimulating fear when short term results are bad, and euphoria when results are positive.
These emotions are investor’s worst enemies.
After this long premise, I want to clarify that this article is addressed to those who want to invest their money for themselves, with the only aim of reaching their personal financial goals. It will not be useful to those who want to make fast money, that is not the purpose of this article.
As I said before, most of financial operators tend to have a more short-term time horizon, therefore the main advantage we can have over them does not consists in having a larger capital to invest, better information, or better analysts, that is impossible.
That is impossible because hedge funds and other institutional investors employ hundreds of well-paid professionals, coming from the best universities in the world, and have access to the best informations available. It is not a fair game, therefore the main advantage we can have over them is a long-term time horizon.
In fact, contrary to them, we do not have to report our quarterly performance to investors, we can invest all the money we have when we see opportunities, or on the contrary we can keep the large part of our portfolio in cash if we think that the market is overvalued.
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Patience is a crucial factor in many stages of the investing process. For example, when looking for opportunities is important to be patient and to wait for the right opportunity, this is not easy because is common to be in a hurry to invest when a large part of the portfolio is held in cash, in these situations investors suffer from fear of missing out opportunities.
On the other hand, is not unusual to go through bad times in financial markets, not necessarily like the financial crisis of 2008 but months/years where returns are negative, where our holdings may be worth 30–40% less than what we paid for them, at such moments patience is crucial, it can help you not to make the mistake that everyone makes when they face this kind of situation, sell.
In fact, as investors that look at the long-term is important to always keep in mind this quote attributed to Baron Rothschild.
“Buy when there’s blood in the streets, even if the blood is your own.” Baron Rothschild
Having a clear long-term time horizon makes it a little bit easier to be patient when things are not going in the direction we expected, that is because when we have a long time frame we can accept that there can be bad moments, we focus on the bigger picture, it helps to mitigate emotions, which is a winning attribute of the best investors.
As you can see in the following graph which shows the S&P 500 index over a period of almost 100 years, it also highlights in grey the periods when major recessions hit the stock markets and the economy. From this graph is clear that in those periods stocks went down for a while, but nevertheless they recovered pretty well and the overall trend kept going up.
One other major force that we can use at our advantage by playing the long-term game is compound interest. It is the result of reinvesting interest, so that interest in the next period is then earned on the principal sum plus previously accumulated interest.
As shown in the following picture, the effects of compound interest in the long-term are impressive, here you can see the same investment with the same return on interest of 8% per year (the investment highlighted by the blue line is considered without reinvesting the 8% received annually, while the investment highlighted by the red line is considered with a reinvestment of the yearly 8% return).
The two lines for the first 10–15 years are almost parallel, since then they start to deviate, to the point where, after 40 years the value of the “red line investment” is almost 5 times higher than the “blue” one.
This was an example of the wonders of compound interest, that are enjoyable only for those who invest for the long-term.
I wanted to share these ideas about the importance of having a long-term time horizon because I think that it could be the greatest competitive advantage that individual investors have over the big players on the financial markets. This view of financial markets not as a place where you can make fast money, but a place where by analysing different opportunities, decide a strategy and sticking to it, you can have great returns on your capital over time and reach your financial goals (early retirement, pay for the education of your children etc.).
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