Financial goals exist on a timeline that stretches into the future. Some goals, like buying a new car, might take place in the near future, perhaps inside just a couple of years.
Others, like retirement, may be decades away. Investment strategies for these goals typically vary. Here’s a look at long- and short-term investment strategies and some of the important considerations that come with each.
Related: 6 real questions about investing— answered
What Is a Long-Term Investment?
Long-term investments are typically held for a few years or more to help fund long-term goals like saving for a child’s college education or retirement.
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Long-term investments may gain value slowly, and investors usually build them into balanced portfolios that consider their goals, risk tolerance and time horizon.
Any investment can be a long-term investment, but the foundation of a long-term investment portfolio is typically a mix of stocks, bonds, and some cash. Long-term portfolios may hold other investments, such as real estate.
Each of these investments has its own risk and reward profile. Stocks tend to be riskier than bonds, but they also have the propensity to offer greater returns. Bonds are much less volatile than stocks, but the trade-off is lower returns.
Long-term investments are typically held for a few years or more.
The ratio of stocks to bonds that an investor holds will have to do with their risk tolerance and time horizon, which may be related to their age. Often long-term investment goals allow individuals to take on more risk.
That’s because if an investor doesn’t need their money for several decades. They may have time to recover from short-term downturns in the market. For example, if an investor is saving for their retirement in 30 years, their portfolio might contain a majority of stocks to help them save as much as possible during that period.
The relatively far-away horizon means that if the market hits any rocky patches along the way, the investor can likely ride them out. As the investor approaches retirement, they may rebalance their portfolio, slowly shifting away from stocks toward more conservative investments like bonds.
This move is intended to help reduce volatility in the portfolio and help ensure the investor’s money is there when they need it.
What Is a Short-Term Investment?
Short-term investments are typically used to help pay for near-term goals, such as saving three to six months’ worth of expenses in an emergency fund, saving to buy a new car or saving for the down payment on a home.
Because these goals will take place in the near future (and investors will need relatively quick access to their cash), short-term investments are usually held for just a few years or less. Some day traders may hold certain investments for just a matter of hours.
Investors can hold almost any kind of investment in the short term, including stocks, bonds and mutual funds.
Stocks can be volatile in the short term, which can open investors up to the risk that their investments will underperform, leaving them short when the time comes to cash out.
As a result, investors may want to consider less risky investments, such as certificates of deposit, high yield savings accounts, or short-term bonds that repay bondholders’ principal back in a few years.
While these investments may not offer the potential higher returns of investing in the stock market, they make it more likely an investor’s money will be there when they need it.
In fact, certificates of deposit and high yield savings accounts are FDIC insured up to $250,000.
What about Day Trading?
Some people may remember stories from early days of online investing about people quitting their day jobs to day trade, getting rich betting on the market in the comfort of their pajamas.
Day trading is a style of very short-term investing in which investors hope to buy and sell stock for a modest profit, usually in the same day.
By nature, day traders are exploiting volatility in the stock market. As stock prices fluctuate throughout the day, they hope to capitalize on upswings, buying low and selling slightly higher.
While it may sound exciting, day trading is not appropriate for most investors. That’s because the profits for day trades can be relatively small, and even those can be eaten into by fees and taxes.
By nature, day traders are exploiting volatility in the stock market. What’s more, while it’s possible for investors to turn a profit day trading, it’s equally possible that they will lose money.
Day traders are competing with professionals who have lots of sophisticated tools and information at their disposal to help them succeed. These professionals are often moving large sums of money and attempting to turn a profit on tiny gains. Even these experts fail to time the market much of the time.
Long-Term Investing and Compounding Interest
Compound interest is one of the more powerful tools available to investors and is the reason that even seemingly small amounts invested today can go a long way in the future.
The idea is simple: Investments hopefully earn returns, and when those returns are reinvested they start to earn returns as well. As a result, investor savings can grow at an exponential rate.
To get a clearer idea of how this works, investors can use a compound interest calculator to input various starting investment amounts, regular contributions, and interest rates.
For example, an investor makes a hypothetical initial investment of $1,000 at a 6% interest rate. They add $50 to that investment each month for the next 30 years, with interest compounding annually. In that time period, the investor’s money will grow to more than $53,000. But the kicker is their total contributions only equal $19,000. Thanks in large part to compounding interest, the investor was able to earn $34,000 on their investments.
While compounding interest begins to work its magic as soon as an investor starts to invest, the benefits are long term in nature. The longer the investor can allow their returns to compound, the more money they may be able to make.
As a result, investors may want to consider compounding as more a part of a long-term investment strategy than a short-term strategy.
Tax Differences Between Long- and Short-Term Investments
The federal government charges two different capital gains tax rates on investment profits depending on how long an individual holds their investments.
Rules for capital gains taxes use net gains, so they also take into account the possibility that investors will lose money on an investment. If an investor buys a stock at $10 and sells it at $15, the capital gain on that stock is $5.
The investor will owe taxes on that gain. However, if the same investor buys a stock for $10 and sells it for $5, that’s a loss of $5, and their net gain is $0. At that point the investor would owe no taxes.
Investments that are sold in a year or less are subject to short-term capital gains. The short-term capital gains are taxed as regular income and are determined by an investor’s tax bracket.
Investments that are sold after more than a year are subject to the current long-term capital gains rate which is equal to 0%, 15%, or 20%, depending on an investor’s income and the type of investment.
The long-term capital gains rate might be much less than their income tax rate, which can help incentivize investors to hang on to their investments over the long run.
Investors considering short-term investments of less than a year should be sure to factor in the cost of paying the higher short-term capital gains tax rate.
Finding the Right Approach
Whether an investment is meant for the short or long term can have a big impact on whether an investor chooses an active or passive investment strategy.
Active Investing for Short Term Goals
Active investing is a hands-on approach to investment and often goes with a short-term investment strategy.
Active investing might mean hiring an investment manager who will handpick investments, buying and selling them in an attempt to beat the market. Because of their active involvement, these managers often charge relatively high fees.
Individual investors may also pursue this strategy, choosing investments themselves and deciding when to buy and sell. This approach can be much cheaper than hiring a professional.
An active strategy may work well for an individual saving for a near-term goal who wants the flexibility of being able to choose specific financial instruments, such short-term bonds, to help them save.
Passive Investing for Long Term Holding
Passive investing is a relatively hands-off strategy in which investors attempt to match the movement of a market index, often by using mutual funds, exchange-traded funds or index funds. For example, some funds might track the S&P 500, owning all of the companies tracked by that index at the same proportion and percentages they make up there.
Passive investments are not necessarily trying to capitalize on short-term movements in the market. Rather they are trying to track the market over the long-run. Passive investment strategies often come with low or no fees.
Any index is likely to experience ups and down. Investors taking a long-term approach may have time to ride out rocky patches.
Holding Short-Term vs Long-Term Investments
Investment time horizon can also play an important role in where an investor holds their investments. Short-term investments such as CDs and high-yield bank accounts can typically be opened at an investor’s bank.
To invest in securities, short-term investors will need to open a brokerage account. Investors can place orders to buy and sell stocks and bonds through a broker, online or by phone.
Brokerage accounts are taxable, meaning that any gains an investor makes are subject to capital gains taxes. Investors can sell securities and withdraw their funds at any time.
Long-term investors may want to consider a number of different investment accounts to help meet their various long-term goals. An investor saving for the college education of a child might consider a tax advantaged 529 investment plan.
Long Term Investing with a 529 Plan
Parents, as well as extended family and friends, can contribute to these accounts. Funds inside the account can then be invested in a range of investments, including mutual funds and exchange-traded funds.
Investments grow tax-free inside the account and are not subject to capital gains tax. Withdrawals from the account are also tax-free as long as they are used to cover qualified education expenses, such tuition, room and board, fees and books.
Withdrawing the money for any other reason can subject investors to income tax and a 10% penalty on earnings.
Long Term Investing with a Retirement Plan
Retirement is perhaps the ultimate long-term goal for many investors. The government is very interested in incentivizing you to save for this period of your life, so they provide a number of different options for savings accounts, including 401(k)s and traditional and Roth IRAs.
Traditional 401(k)s are employer-sponsored plans that allow eligible employees to set aside a portion of their pre-tax paycheck into an investment account. They can usually invest their funds in a limited suite of investment options, such as mutual funds or target-date funds.
Investments grow tax-deferred, which can supercharge growth when combined with the power of compounding interest.
After age 59-and-a-half, investors can make withdrawals, which are subject to income tax. Withdrawals before that age are subject to income tax and a 10% penalty, although there are some exceptions to that rule.
Retirement Options other than a 401(k)
Workers who don’t have access to a 401(k) — or even those who do and want to save more — may want to consider a traditional or Roth IRA. Investors can fund traditional and Roth IRAs up to certain limits and invest the money however they want.
Traditional IRAs are funded with pre-tax money. Funds grow tax deferred and are subject to income tax once they are withdrawn after age 59-and-a-half. As with 401(k)s, withdrawals made before this point are subject to income tax and a 10% penalty.
Roth IRAs, on the other hand, are funded with after-tax dollars. Investments inside these accounts grow tax-free and are not subject to income tax once they’re withdrawn after age 59-and-a-half.
Each of these retirement accounts potentially ties up investors’ money for decades, and early withdrawals are subject to stiff penalties. They should be considered chiefly as long-term investment tools.
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This article originally appeared on SoFi.com and was syndicated by MediaFeed.org.
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