Investment Risk: A long term view

by Adam on May 14, 2010

Part 2 of the Magical Penny series on Investment risk. Today we’re looking at the importance of a long-term horizon to take advantage of investment risk. Part 1 is here.

The biggest difference between saving in a savings account and investing in the stock market is when you go to check your account once a month the balance could be lower than what you put in!

This is a serious sticking point that puts people off investing but a fluctuating value is an integral part of what investing is about: you are putting your money into businesses that are constantly reacting to a changing world so valuations inevitably change too.

In reality even your money in a savings account is fluctuating in value: The only difference is you do not see the fluctuations as the bank smoothes it over to give you the illusion that all your money is there -it’s why a bank would not be able to pay out all the money in all the savings accounts at the same time -because bank assets are invested and fluctuate in value.

Whilst the idea of losing some of your invested pennies is a legitimate fear, you should still be learning about investing and eventually start investing yourself to take advantage of a long-term investing horizon:

cautionAs you learn more it may be tempting to try to make some quick money in the short term using the stock market. However it’s not recommended unless you have a huge amount of time and money to practice and trade with. You won’t find anything helpful here on Magical Penny on this subject.

Think Long Term

A long term horizon means you are investing for the distant future, like retirement, a dream home or anything you may want many years from now.  That said, whilst it seems far away, it will come quicker than you think (so I’m reliably informed) so starting early is good!

Time Heals…

For most of us in our 20s and 30s we have a long time to grow our pennies so it shouldn’t mean much whether the FTSE100 (Financial Times Stock Exchange: a collective term for top 100 number of shares on the London Stock Exchange) or any other index or share is going up this week or going down. In fact, by investing long term (through a buy and hold strategy) it’s not important (nor recommended!) to keep track of every movement  in value every day.

By investing with a long-term view we can  take more ‘risk’ –giving us a greater range of possible values for our savings. And as we have so much time, our money has time to grow because business valuations tend to go up over time (depending on the time period of course but that’s another blog post!). Starting early and taking advantage of a long time horizon can therefore be absolute magic for growing our pennies.

Trick of the Mind

It’s easy to write that “valuations in the short-term don’t matter”, but it’s a completely different thing to put £1000 of your hard-earned savings in the market and look back a few months later and see that it’s down to £700! (or even worse like the time when my £1500 investment halved in value over only a few months).

It’s hard to tell how you will feel until you experience the apparent loss of your money yourself, but remember, you should only be investing pennies that you don’t need for over 5 years so when it looks like your investment has gone down in value, it doesn’t matter because that loss is not ‘real’ until you sell –something you won’t need to do for many more years.

The Take-Home Point:

A long-term horizon can really help you grow your pennies because not only do your pennies have time to grow into substantial sums (as you are investing in value-creating businesses through the stock market),  but the market value fluctuations can be mostly ignored as they are meaningless if you are decades away from when you intend to sell -something to keep in mind not only when your investments are down but when they double and triple in value.

Now there’s a happy thought to ponder over the weekend!

Is there anything else that’s putting you off from investing?

{ 2 comments… read them below or add one }

Jon

Without a bank’s assets being tied to the gold standard they could never pay back their investors if they all cashed in anyway, but that’s the miracle of modern market capitalism (gah…). But yes, at a smaller scale the clearing banks do fail to balance our deposits everyday; but hopefully not so much that they northern rock!

Marko Piplica

Would a world currency help investors?
Dollars, pounds, euros etc all fluctuate. One currency, with one world bank, may aid stability.
But would it restrict freedoms? Economic cycles in different nation states are unlikely to be synchronized. Interesting ?? Does anyone know of any mathematical economic model which could test this concept?

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