Short-term Versus Long-term Investments
By: Daniel Eskin Tue, Mar 16, 2010
So you’ve saved up money from your summer job or internships (or career), and are ready to dabble in the world of investments. Fantastic! Choosing investments is both exciting and challenging; there are numerous investment options that you can explore, and the ones you may end up choosing will likely be based on your personality and risk-tolerance.
The most obvious way to split investment types pertains to investment horizons – there are short term investments and long term investments. These coincidentally align with the way the finance world is split, as you may have read in the past, into the buy side and the sell side. The sell side is more focused on short term investments, such as trading equities, options, forward contracts, and derivatives. On the other hand, the buy side is focused on long-term wealth allocation to numerous investments, some of which can also be long term equities and instruments, but also vehicles such as bonds, some ETFs and foreign currency.
What’s the difference?
Short terms investments are expected to show substantial gains in a short amount of time. For example, expected currency impacts due to an upcoming government legislation change or stock options with an expiry date would classify as short term investments, and often range from a few weeks to a few hours, even minutes at the extreme. On the other side of the playfield, long term investments often have a broader investment horizon such as a year, 2 years, 5 years, or even “forever”, an investment horizon often associated with investing guru Warren Buffett. Long term investments are expected to produce value for a long period of time, such as the stock of a persistent and global company such as Wal-Mart or British Petroleum.
Which is better for me?
The important thing to remember in finance is that risk is often (there are exceptions) correlated with return. The higher the risk, the more profitable an investment can be. On the other hand, the safer an investment is considered (i.e. bank GICs), the lower the return is.
On that train of thought, short term investments have incredible potential in the short term, but for that same reason, are often categorized as more risky investments due to the high volatility and fluctuations they can undergo. Consequently, short term investments often require more attention since the price can change without warning, and often requires greater expertise in the financial markets as they are usually more technical in nature. The chase for a higher yield often lays in short term investments at the risk that a lot of money could be lost.
Long term investments, when chosen with tact and careful analysis, can provide steady and reliable returns for years. For example, purchasing stock in a solid company like Procter & Gamble is not much of a gamble (pun intended), since the company will likely continue flourishing for a long time to come, and the underlying value of its shares involves less risk along the way with a steady return. But, for the safety provided, PG knows it does not need to pay as high dividends, and thus long term investments usually provide lower annual returns.
For the reasons above, people who are closer to retirement invest for the long term. Younger people can handle more risk since they don’t need a nest egg to rely on in their retirement risks. But, as always, there are exceptions to both sides.
Now that you have a good idea of what both consist of, try to assess your risk tolerance and see what types of investments fit better for you. Here’s a way to assess your risk tolerance. http://njaes.rutgers.edu/money/riskquiz/
Side note on Mutual Funds and ETFs (on long-term investing)
Mutual funds have been around for ages, and are often regarded as the simple investment alternative for folks who do not want (or have the technical proficiency) to conduct their own investment research, such as families, doctors, plumbers, and most importantly, young people. Unfortunately, even though mutual funds have a “safe” and “reliable” image, they are one of the worst long-term investment alternatives there are. Here is why. On the other hand, a recent investment vehicle known as ETFs (exchange traded funds), have paved the way for a new type of long term investment. Here’s a great article for why ETFs, specifically active ETFs in this case, trump mutual funds.
Image credit: Amanda Woodward under a Creative Commons license
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Re: Mutual Funds and ETFs
There are advantages and disadvantages for both types of investments. For investors who are starting out and making regular contributions, a low cost mutual fund such as TD e-Series (MER of 0.31-0.48%), may cost less than paying a commission every time to buy a similar ETF.
What it ultimately boils down to is cost. All things being equal (i.e. funds that track the same index for example XIC vs TD900), the ETF or mutual fund that costs less will be more beneficial for the investor. Since the value of each investor's assets and contribution schedule varies, the commission costs will be different, as will be the costs incurred through MERs. Hence, each situation will be different. In other words, it is difficult to say which type of investment is better as it will vary from investor to investor.
At some point, the MER savings will outweigh the commission costs, and purchasing ETFs will cost less. This can be measured by total commission paid vs. the savings in MER difference.
Here is a comment from another article which shows how to calculate the break even point.
"For all those looking for a simple equation for how much money is needed to flip from one fund to another (or fund to ETF , etc.) from a higher MER to a lower MER based on covering your commission costs in one year of savings, well here it is:
Minimum amount needed = (Commission charged to sell higher MER($) + commission charged to buy lower MER ($))/(Higher MER% – Lower MER%)
Basically it is the total commssion cost in $ divided by the difference in MER%.
Enjoy,
Ed"
http://www.canadiancapitalist.com/switching-from-...
Wilson, awesome comment – good to hear from you again! I totally agree with what you said above – if all things were equal, then whichever fund / ETF cost less would be the better option. Key idea being "all things were equal".
The point I was trying to make is that mutual funds rarely perform consistently across the years. There's been a mass amount of research done on this and the best source I can recommend is Contrarian Investment Strategic by David Dreman. If you link to the article I mentioned that I wrote about a year ago, I explained why mutual funds rarely do well. In the book, he DOES recommend how to find a good mutual fund, but they are few and rare.
Even the best performing funds very often flat or go negative in subsequent years due to reasons mentioned in my book/article. I only offered ETFs as one alternative, but frankly, I would stay away from mutual funds fully and invest in actual stocks instead. So, I do agree that if all things were equal the cheaper would be the better investment, but unfortunately, I don't believe they are.
I forgot to say, great article by the way. I commented on your side note and forgot to commend you for the other 90%.
Based on what I've read, I agree with you 100% that most mutual funds rarely outperform the market, over the long term. These ACTIVELY managed funds usually have high MER that cut into earnings during the best performing years, and in bad years, make things worse.
That being said, there are mutual funds that track the major market indicies with very low MERs. These PASSIVELY managed index funds replicate the returns of the index. Using the market index as a baseline, we can compare different types of investments that track the same index, by looking at their returns compared to the market return. This was what I meant when I said things being equal.
So in short, avoid actively managed mutual funds, but don't discount low MER index funds simply because they are "mutual funds".
You prepared a number fine points there. I did a good solid research for this particular issue and found out generally people will definitely agree with your website. Thanks