Far too many long-term investors make the mistake of developing a short-term mentality when it comes to their stocks. Specifically, if you're investing for the long-term, you really shouldn't care about the day-to-day movement of the stock market, no matter how dramatic.
What you should be worried about is the big picture. Timing the market is a futile effort, and so is trying to be right 100% of the time. Here are three truths our experts say long-term investors need to accept and use to their advantage.
One thing long-term investors should accept is that you cannot time the market. Stocks will look "cheap" or "expensive" at various times, but there's no reliable way to predict what's coming next.
As an example, consider if you had bought an S&P 500 index fund the day before Black Monday in 1987, right before the market plunged 22.6% in a single day -- arguably the worst possible time to buy in the past 30 years. Since that time, the S&P 500 has produced a total return of 1,330%, or an average of 9.5% per year, including that awful crash. In other words, even though your portfolio would have lost nearly a quarter of its value immediately, you would still be sitting on some solid long-term gains.
On a related note, thanks to the principle of dollar-cost averaging, long-term investors can obtain a better-than-average price on any stock so long as they continue to buy a consistent dollar amount of shares at regular intervals.
As a simplified example, let's say you invest $1,000 in a stock trading at $40, giving you 25 shares. Then, a year later, the stock is trading for $50, and you invest another $1,000, giving you another 20 shares. Even though the stock had an "average" price of $45 between the two purchases, your average cost per share is $44.44.
Dollar-cost averaging allows you to buy more shares when stocks are cheap and fewer shares when stocks are expensive. Mathematically, so long as you keep the value of your purchases constant, you'll always get a below-average price for your shares. So, don't worry about a stock's price at any given time; it's much more important to develop a good strategy for buying and holding.
If you truly have a long time horizon, then some of your stock picks will inevitably fall below the price you paid for them, often for years at a time. If you're unfortunate enough to pick a high-quality company's stock at a time when its valuation is particularly high, then a return to more typical earnings multiples can leave you playing catch-up for a long time.
There's a silver lining for those who save more money to invest regularly, though. As Matt describes in more depth, if share prices of your favorite stock fall, you'll have the opportunity to buy more shares more cheaply than you otherwise would have. By contrast, those stocks whose prices gradually rise might make you feel better, but subsequent purchases will buy fewer shares, and your overall returns will often turn out to be lower.
Even if you don't add to your investment, though, the key is to choose companies whose business models will succeed in the long run. Even if your stock spends years getting back to breakeven, a successful company will eventually reward shareholders with solid returns. All it takes is patience to go the distance and hold on long enough to see profits from your position.
In my nearly two decades of investing, I've yet to come across anyone who was never wrong, and I'm pretty confident it'll be that way throughout my lifetime. In fact, some of the best stock-pickers in the world will only be right about 60% of the time. External and unforeseen factors can sometimes turn that perfect trade into a nightmare.
However, the advantage of being a long-term investor is that you can afford to be wrong sometimes.
Short-term traders often deal with high commissions costs that eat into their profitability, and they lack the patience to see their small pops develop into meaningful long-term gains.
The long-term investor, on the other hand, has time on his or her side and can afford to jettison companies that no longer meet their portfolios' investment thesis while letting the winners ride. It's perfectly acceptable to take 10% and 20% losses over time if a company no longer passes spec, because the winners can devour these losses over the long run.
Take streaming service Netflix (NASDAQ:NFLX) as a perfect example. Short-term traders could easily have netted a 100% gain between September 2012 and December 2012 (and likely did lock in those gains). Just as easily, they could have watched their investment rapidly lose 70% in the summer of 2011. The long-term investor, though, is sitting pretty. If our fictitious investor bought Netflix in September 2012, then they've seen their shares rise in value by a factor of 10. If they've held Netflix over the past 10 years, then they're up 3,435%! That alone could cancel out dozens of losses and give long-term investors plenty of opportunity to pick a few home-run stocks to retire on.