Long-term investing, as opposed to short-term trading, has been touted by many financial experts as the smarter approach for individual investors. One of the most compelling reasons is that long-term investments allow your money to work for you through the power of compounding. By being patient and letting your money remain invested over extended periods of time, the returns generated get reinvested and can snowball into significantly higher total gains. This article will elaborate on how compounding offers perhaps the single biggest advantage for long-term oriented investors.
Long-term gains compound over time
The basis of compounding is that investment gains get reinvested to generate additional gains. As opposed to simply tallying up linear gains year after year, compounding creates exponential growth as your reinvested returns start earning returns themselves. For example, a $10,000 investment that earns a 7% annual return would be worth $10,700 after the first year. In the second year, the 7% gain on the new higher balance of $10,700 would amount to $749, giving a portfolio value of $11,449. Extend this process over 10, 20 or 30 years, and the compounding effect becomes very powerful.
Time and discipline are key
In order for compounding to work its magic, two key requirements must be met – the passage of time and the discipline to let returns remain invested. Trying to time the market undermines compounding, since missing out on even a few of the market’s best days can slash long-term returns. Similarly, withdrawing investment income as it is earned prevents those gains from being reinvested. Having the patience and discipline to buy and hold quality investments for the long-haul is essential to harnessing the full benefits of compound growth.
The power of compounding is perhaps the most compelling reason why long-term investing makes sense for most individual investors. By being patient and letting investment returns compound over extended periods, investors can accumulate significantly greater wealth than through short-term trading.