Investing for the long term
Long-term investing harnesses compounding and diversification. This lesson explains general principles and is not personal investment advice.
Why invest
Cash savings may not keep pace with inflation over long periods. Investing in diversified assets such as stocks and bonds has historically offered higher long-run returns, though with ups and downs. Investment horizon matters: money needed soon is usually kept in safer assets.
Retirement accounts
In the US, tax-advantaged retirement accounts include employer 401(k) plans and individual retirement accounts (IRAs). Traditional accounts give tax deductions now and tax withdrawals later; Roth accounts use after-tax contributions with tax-free qualified withdrawals. Contribution limits are set annually by the IRS.
Employer matches
Many employers match part of employees' 401(k) contributions, for example 50 cents per dollar up to 6% of salary. Not contributing enough to get the full match leaves free money on the table, which is why educators often suggest capturing the match before other investing.
Diversification and index funds
Diversified, low-cost index funds spread money across hundreds or thousands of companies, reducing the risk of any single company failing. Because most active funds underperform their benchmarks after fees over long periods, many educators recommend low-cost index funds as a core holding.
Asset allocation and risk tolerance
Asset allocation, the mix of stocks, bonds, and cash, should reflect time horizon and risk tolerance. Target-date funds hold more stocks for those far from retirement and gradually shift toward bonds. Rebalancing periodically keeps the mix on target.
Avoiding common mistakes
Common mistakes include trying to time the market, chasing last year's best performers, paying high fees, panic-selling in downturns, failing to diversify, and investing money needed in the short term. Staying invested through volatility has historically rewarded patient investors.
Inflation and real returns
Inflation erodes purchasing power: at 3% inflation, prices roughly double in 24 years. Long-term planning should focus on real (inflation-adjusted) returns. Treasury Inflation-Protected Securities and I bonds in the US offer inflation protection.
Worked example
Two people invest 300 dollars a month at a 7% average annual return. One starts at 25 and stops at 35 (10 years, 36,000 contributed); the other starts at 35 and continues to 65 (30 years, 108,000 contributed). At 65, the early starter has roughly 420,000 dollars and the later starter roughly 365,000, despite contributing a third as much, showing the power of starting early.
Key takeaways
Investing helps savings outpace inflation over long horizons, with short-term volatility. Tax-advantaged accounts include 401(k)s and IRAs, traditional or Roth. Employer matches are valuable. Low-cost diversified index funds are a common core holding. Asset allocation should match time horizon and risk tolerance; target-date funds automate it. Avoid market timing, high fees, and panic selling. Focus on real returns. Starting early is powerful.
Flashcard
Time until money is needed
Check your understanding
Why might someone who invests for 10 years starting at age 25 end up with about as much at 65 as someone who invests for 30 years starting at 35?