The idea of buying and selling shares over a short-term time period can be attractive to some. It could mean the effects of compounding turn a modest sum of money into a fortune if you're lucky. Furthermore, short-term trading can also be exciting and a lot of fun, so it's unsurprising that many people are attracted to it.
However, history shows that the most successful investors tend to be focused on the long term. Here's why.
Potential rewards
There are a number of highly successful long-term investors. The likes of Warren Buffett and Charlie Munger instantly spring to mind. They have generally returned around 20% per annum over their investment careers. While this level of return is unlikely to make any investor rich in the short run, when compounded over a long period it can lead to significant returns. For example, over a 30-year time period it could propel an initial sum of money around 237 times higher. As such, even modest sums could become seven-figure portfolios.
Of course, most investors may be unable to deliver returns which are as high as 20% per annum over a 30-year time period. However, even returns which are in line with those of the wider index could end up turning a small portfolio into a large one in the long run. For example, returns of 8% per annum over the course of three decades would equate to an end value which is 10 times larger than the starting amount. As such, the potential rewards from long-term investing are evident.
You only have to look at the long-term returns from the likes of REA Group Limited (ASX: REA) or private hospital operator Ramsay Health Care Limited (ASX: RHC) to see how the buy and hold strategy can send your net worth into orbit over time.
Risks
In contrast, there is a lack of short-term traders who have made billions in recent years. Certainly, there are success stories. However, there seems to be a lack of success over a prolonged period. This indicates that short-term trading is not only risky, but incredibly difficult.
In fact, it could be argued that the short-term movements of share prices are somewhat random and that it takes time for the effect of a new business strategy, political event or changes to the macro-economic outlook to come to light. In the short run, such changes are incredibly difficult to quantify and it could be argued that short-term trading is more reliant on luck and less on skill than is the case for long-term investing.
Certainly, long-term investing is not without risk. Investors make mistakes and this leaves them with losses from time to time. However, since they have a long-term outlook, they can afford to sit on paper losses for weeks, months and even years as they wait for the catalysts they have identified to have an impact.
Short-term trading, on the other hand, often uses stop losses. They mean that a position is automatically closed if a specified level is reached. Therefore, there is a much narrower margin of safety than is the case for long-term investing.
Takeaway
Short-term investing has the potential to be rewarding, but the risks involved mean that on a risk/reward ratio it is less attractive than long-term investing. It may be more exciting and the potential for high, fast returns may attract some investors to it.
However, by focusing on the long run it is possible to build consistently high returns, just as the likes of Buffett and Munger have done. Doing so may not be easy, but by focusing on risk as well as potential return, even a modest sum could be a significant one in future years.
