8 reasons why investors should invest for the long term. In Australia, we see the growth in low-cost brokerage platforms like SuperHero, SelfWealth and eToro which are shifting the market towards higher rates of retail participation. Compounding and reinvesting dividends. As a company grows, the size of the dividends it pays out to shareholders is likely to also grow over time. Market volatility can create fear and uncertainty which can lead to bad investment decisions.
If you are new to investing or even a seasoned professional, finding the right place to invest to ultimately grow your wealth can be a daunting and stressful task. Knowing what to invest in and when to invest are potentially the biggest decisions one will make.
Your individual investment approach or philosophy will ultimately determine how you invest, however due to the digital world we live in and information being more readily available, the manner in which people transact has changed dramatically.
Across the world, free brokerage micro-trading apps such as Robinhood, are gaining traction highlighting the appetite of people venturing into investing. In Australia, we are seeing the growth in low-cost brokerage platforms like SuperHero, SelfWealth and eToro which are shifting the market towards higher rates of retail participation. Couple this with how people are easily accessing information from sources such as Twitter or Reddit for their investment insights, it’s easy to argue that investor time horizons are increasingly shorter term and investor motivations skewed towards the notion of trading rather than investing.
At NAOS, we look for undervalued, quality companies in which to invest. We invest for the long term, with a typical investment time horizon of 5+ years. We believe it’s important to take a long term and patient view while looking for quality companies that can generate sustainable levels of cash not only to reinvest back into the business but to reward shareholders in the form of dividends.
Outlined below are 8 reasons why investors should invest for the long term.
1. Compounding and reinvesting dividends
“Compound interest is the 8th wonder of the world. He who understands it, earns it; he who doesn’t, pays it.” Albert Einstein
When considering investing in its simplest form (assuming no follow-on investments), there are really only two key aspects:
I. The return you receive for your investment.
II. The length of time you hold the investment.
So taking Einstein’s logic and considering what you can control more, time not return, it is beneficial to allow time to provide the greatest benefit.
By investing in a company that is growing, that company has the ability to reinvest in itself to assist in generating further growth. As this growth process continues, it can start to snowball into large numbers. An initial investment could multiply many times over in the course of a multi-year time span.
As a simple example, you can see the value of compounding over a longer period of time. If you had an investment worth $100 which paid out a 10% yield, if you re-invested the interest received each year, total amount received would be $159.37 compared to $100.00 after 10 years.
To calculate the effect of compounding, you can use this formula:
A = P x (1 + r)n
A = ending balance
P = starting balance (or principal)
r = rate of return per period as a decimal (for example, 2% becomes 0.02)
n = the number of time periods
2. Dividends and franking credits
A dividend is the distribution of a company’s earnings to its shareholders. Dividends are a fundamental component of investing in equity markets. As a company grows, the size of the dividends it pays out to shareholders is likely to also grow over time. Many companies will provide shareholders with the ability to reinvest their dividend entitlements back into the business for additional shares (instead of receiving a cash payment). Using the above lesson on compounding, a dividend reinvested in return for shares can continue to benefit from compounding over time.
In Australia, an additional benefit of a dividend comes in the form of franking (or imputation) credits. When a company has paid corporate tax and then pays a dividend to investors, the company can choose to pass on to shareholders the benefit of this corporate tax payment This is done through the form of franking a dividend. If a dividend is franked, shareholders can claim this franking credit and potentially receive a reduction in their income tax. The benefit of the franking credits will vary from one investor to the next depending on their individual tax rate
The chart below outlines the share price movement vs the total return (share price + dividends) of the ASX All ordinaries index for the past 15 years. This clearly displays the positive impact of reinvesting your dividends and staying invested over the long term. It is worth pointing out that the below graph does not account for the benefit of franking credits.
3. Time can reduce market volatility
Market volatility can create fear and uncertainty which can lead to bad investment decisions. When you take a long-term view to investing, you gain perspective which can remove the short-term noise and pressure. The below chart captures the ASX All Ordinaries during the Global Financial Crisis (GFC) which fell ~50% over 16 months.
While the above is somewhat gut wrenching, it needs to be put into context. The below chart is of the ASX All Ordinaries over 30 years. The GFC period is still clearly visible however through time, the market has well and truly recovered and continued to grow. In recent times, the same can be said for the severe drop in early 2020 due to the onset of the COVID-19 pandemic.
“The stock market is a device to transfer money from the impatient to the patient.” Warren Buffett
4. Less trading means fewer fees
Trading costs for retail investors have decreased considerably over the last decade and due to new brokerage entrants into the market, pressure on fees looks set to continue. Whilst cheaper trading costs are clearly a positive for investors, if investors trade frequently and try to “time the market”, it can be costly in terms of brokerage fees impacting performance.
According to a 2020 ASX Investor Study, 27% of the Australian investment community traded more than 40 times in the last twelve months (source - LINK) and when CommSec charge $19.95 for brokerage up to $10,000 dollars, the fees can quickly add up.
5. Management teams think in years not months
“You have to think of yourself as an owner of a business, rather than an owner of a piece of paper” Li Lu, Himalaya Capital
At NAOS, we take the view that we have ownership rights over assets and the cash flows a business generates, however are fully aware that a management team is in place to execute a strategy that has been publicly shared with investors and the market. It would be inappropriate to expect a management team to deliver on their strategy overnight. We all know Rome wasn’t built in a day and neither was any successful company. If a management team think in years not months, investors should factor this thinking into their own mindset.
The illiquidity premium is the additional return investors expect to receive for holding less liquid assets. This can be common in the small and micro cap space. Like all things, the illiquidity premium/discount is not a concern when markets are calm and rising but becomes prevalent when markets face periods of stress. If forced to sell, investors may be doing so when there are few buyers at a certain price, and hence could be selling into the market at the worst possible time. If investors have a long-term mindset and little to no liquidity requirements, investors can benefit from the premium over the long term with the potential to provide liquidity to the market on their terms.
Under Australian Taxation law, investments that are held for greater than 12 months receive a concession on capital gains tax. Hence there is a clear benefit to holding investments long term.
8. Little up-front capital required
Unlike investing in property or private unlisted companies, buying shares or listed invested companies have a much smaller minimum investment. Looking at Superhero which has gained popularity with younger generational investors, an investor can start investing with just $100. While this might not sound like much, having a small minimum initial investment plus the opportunity to make regular additional investments, allows investors to start creating their wealth a lot sooner - and it’s worth remembering Einstein’s comment about compounding.