It is logical only when you are investing surplus cash without a specific goal
Like many, you may believe that equity investments should be held for the long term. But do you truly invest in equity for the long term? Or do you think long term when your investments perform badly? If you invest for the long term, why do you take profits when you earn sizeable gains in the short term? Also, why do you continually follow the market if your objective is to hold for the long term? In this article, we discuss the behavioural aspects that drive us to think long term.
Loss vs gains
We like gains. But the fact is we hate losses more than we like gains. That is, a loss of 10,000 gives us more pain than a gain of 10,000 can give us happiness. It is, therefore, natural that we want to avoid losses. That is possible only if you invest in stable-income products such as fixed deposits. The issue is that post-tax returns on deposits are low. You must, therefore, save more if you want to achieve your goal with bank deposits. And that may not be possible, given that you must maintain your desired standard of living and save some to achieve your life goals. So, investing in assets that generate higher expected returns such as equity becomes a necessity.
But with equity comes the uncertainty in the investment outcome, and the regret when your investment turns into a loss. Your brain’s coping mechanism to alleviate the pain from unrealised losses is to think long term. It certainly helps when everyone around you talks long term. So, even if you were to believe that long term is an illusion, you may fall in line with others. Call it social conformity if you will, but it feels safe to typically join the crowd then to take a contrarian view.
Goals vs long term
Long term has no relevance when it comes to achieving a life goal. Here is why. Suppose you are investing to accumulate money to make a down payment for a house in 10 years. If the equity market tanks in the seventh year, thinking ‘long term’ is unlikely to help to meet your goal in the tenth year. What matters is whether you can recover your unrealised losses on your equity investments and make some gains to accumulate enough money in time to pay for the house.
Most of the time, we are investing for some purpose. Staying focused on the goal helps you to manage your equity investments better. Suppose the expected annual pre-tax return on your equity investments is 12%. If you earn returns greater than 12% in any year, you can take the excess profits and move the proceeds into bank fixed deposits.
In any subsequent years, when your equity investments perform poorly, you can move the buffer accumulated in these bank deposits back to your equity investments.
And if you still fall short, you can explore avenues to bridge any shortfall in the portfolio to achieve the goal. Importantly, focusing on the goal prevents from getting caught in the long-term illusion.
We think long term when we carry unrealised losses. We live in the short term when we have unrealised gains. This behaviour to take profits quickly can be attributed to our fear of losing unrealised gains; we are risk-averse when managing gains, and risk-seeking when managing losses.
Your time horizon is clearly defined when you are investing to achieve a life goal. Thinking long term is logical only when you are investing surplus cash without a specific goal. Even then, most individuals prefer to invest surplus cash to capture short-term fluctuations in the market. In any case, we must survive short-term market turbulence to achieve long term returns.
As Keynes famously said in a different context, in the long term we are all dead.
(The author offers training programmes for individuals for managing their personal investments)
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