Investments: Growing Net Worth Through Financial Securities

Financial advisors often warn clients that they should not try to time the stock market.  Indeed, research indicates that individuals tend to buy when stocks are going up and sell when stocks have gone down: a buy-high and sell-low approach that reduces long-term returns.  Conversely, some investment professionals advise clients to implement a strategy known as “buy and hold.”  This strategy has been supported by one of the most successful investors of all time, Warren Buffett.

Patience is a Virtue.  The “buy and hold” strategy advocates allocating a specific portion of an investors portfolio to stocks and bonds (a.k.a., asset allocation) based on such factors as investment horizon, risk tolerance, and growth desirability.  Once chosen, an investor generally maintains the asset allocation for many years with changes occurring only due to significant life events (i.e., marriage, starting a family, retirement, etc.).  Within each investment class (i.e., stocks, bonds, mutual funds, etc.), investor funds are diversified across industries, time horizons, capitalization sizes, and other factors for the purpose of reducing risk and maximizing returns.  Historically, market returns over the long-term have been excellent, and the “buy and hold” strategy attempts to achieve this result for investors.  According to Morningstar’s Ibbotson subsidiary, through 2014, large-company U.S. stocks have annualized returns of around 8% for the past 10 years, 10% for the past 20 years, 11% for the past 30 years, and 12% for the past 40 years. (These returns assume dividend reinvestment and exclude taxes and transaction fees).  Going back nearly 90 years, to the beginning of the Ibbotson data base, U.S. stocks have annualized returns of approximately 10%.  Putting this in perspective, certificates of deposit have recently offered interest rates of less than 1% annually.

Historically, stocks have provided greater return on investment than bonds and cash equivalents (i.e., certificates of deposit, money market funds).  And while this is no guarantee of future success, it is telling that U.S. stocks have been lucrative long-term investments through recessions, depression, wars, turmoil, booms, and busts.

Let us take a look at the long-term increase to a $10,000 investment in stocks that return 7.2% annually.  In this scenario, an investor’s portfolio will almost double in value every 10 years (approximation).  Assuming a start date in 2015, the initial investment of $10,000 would grow to $20,000 by 2025, $40,000 by 2035, and $80,000 by 2045.  As evidenced by this example, a patient investor utilizing the “buy and hold” strategy can achieve significant growth in net worth over the long-term.

Avoiding the Hysteria and Paranoia of Mr. Market.  In his book The Intelligent Investor, Benjamin Graham used an allegory to describe the wild swings in stock prices that are reflected daily by the major stock indices.  Graham instructs the reader to imagine being co-owner of a business with a partner named Mr. Market (a symbolic character representing the stock market index).  Using modern day terminology and diagnosis, Mr. Market has a bi-polar disorder that causes him to display manic-depressive traits on a daily basis.  Depending on his mania/depression for any given day, Mr. Market either wants to buy the reader’s share of the business at high prices or sell his share of the business to the reader at low prices.  The moral of the metaphor is that an intelligent investor avoids becoming caught up in the emotion that produces wild swings in stock prices (i.e., Mr. Market’s daily offers to buy or sell his business).

The lesson from this analogy is an important piece to the “buy and hold” puzzle.  Stock market prices are volatile, and the implications of buying and selling during tumultuous periods carry financial repercussions (both good and bad).  During the two bear markets of this century (2000-2002 and 2008-2009), the broad U.S. stock market dropped by roughly 50% of its value each time.  Such a steep loss and prolonged recovery period can be disheartening.  The damage can be especially severe if it occurs just before purchasing a home or funding a college education.  Retirees drawing down their portfolios can potentially run short of money after an ill-timed bear market.

Tax Considerations for Financial Security Investments.  Skeptical investors may want to sell stocks after a period of price increases and consistent dividends.  While this move aids in reducing exposure to downside risk by locking in profits, selling stocks at a profit can result in capital gains tax.  Short-term capital gains (identified by holding periods of less than one year) are taxes at ordinary rates that range from 10% – 39%.  The basic tax rate on long-term capital gains (classified by assets held for one year or longer) is 15%, but the rate for high-income taxpayers is 20%.  Adding state income taxes (between 4% – 6% in Louisiana) and the new investment income tax of 3.8% can increase the total burden to hefty levels in excess of 25%.

In years when an investor anticipates significant capital gains, a strategy known as tax loss harvesting can be beneficial.  This procedure involves selling securities at a loss for the purpose of offsetting capital gains.  When properly applied, tax loss harvesting can reduce income tax liabilities and assist in portfolio diversification.

Summary.  Achieving adequate returns through investing in financial securities requires patience, discipline, and planning.  All investors should have a plan tailored to their specific needs, and seeking guidance from a financial advisor is one method of facilitating this process.  In general, the “buy and hold” approach can be an effective strategy for successful investing, but it requires a patient, long-term outlook.  While timing the stock market is a risky proposition, reducing positions after a long, upward surge can reduce exposure to downside risk from a pullback.  The tax consequences resulting from such a sale should always be considered before execution.

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