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Long-term investments definition
Long-term investments are not an asset class, but rather an approach to investing that focuses on seeking long-term gains despite potential short-term volatility.
In practical terms, a long-term investment is one you hold for at least a year, and for which you pay long term capital gains taxes upon sale (according to the IRS). But there are more ways to think about long-term investments than how the IRS defines them. While the exact time range of a long-term investment varies from investor to investor, holding for at least five years is considered typical and differentiates long-term investments from the purpose of short term investments and cash in a portfolio.
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Who is a long-term investor?
A long-term investor is a person taking more risks in the short-term to reap potential long-term returns. For instance, a person with 30 years until retirement might do well to put most or all of their portfolio in diversified stocks like index funds or exchange-traded funds (ETFs), whereas someone who is five years away from retirement might want a lower-risk short-term investment.
Long-term investment examples
All assets carry risk, and with stocks, the risk is price volatility, meaning that prices bounce around. When the price of individual stocks fall, there's no guarantee they'll recover. Or, if you sell too early, you won’t benefit from a price recovery.
“Long-term investments are more of a mindset than a specific investment type," says Rockford, Illinois-based certified financial planner Allison Alexander.
Investing in diversified funds and holding them for the long-term can offer the benefits of long-term investing.
Retirement accounts are by definition long-term investments and provide particular tax advantages, as well as penalties for withdrawing early. For example, with an Individual Retirement Account (IRA) you’ll most likely pay a penalty to access the money before age 59 1/2. If you’re investing outside of an IRA or 401(K), investing in funds through a brokerage account can offer similar benefits.
ETFs, index funds and mutual funds
For diversified stock funds, the risk tends to be limited to short term volatility. Take an index fund pegged to the S&P 500 as an example. Even though the fund has up and down years, over the long-term, it’s historically averaged out to a gain. If you’re planning to hold for the long-term, this short-term volatility won’t be as much of a concern. As a result, diversified funds such as index funds and exchange-traded funds (ETFs) could be considered long-term investments.
» Not sure what an index fund is? Learn more about this easy way to enter the stock market
Risks and rewards of bond funds
Similar to stock ETFs, bond market funds are bundles of bond investments offering easy diversification and exposure to the bond market. Bond funds, like bonds, can have different maturities, risk and yield. Bond funds with longer maturities (like 30 years) have higher yields and could be considered a long-term investment, but not for the same reason as stocks. Longer-term bonds pay higher yields because there's a higher risk of inflation eating into your fixed interest payments.
However, the risk and reward profile of bonds with longer maturities might not stack up with the risks and rewards of investing in stocks:
“We're not interested in long term or high yield [bonds], because that offers an element of risk that you're not necessarily rewarded for. Our attitude is if you're going to take risk, you'll be better rewarded for it on the equity side of the portfolio," says Alexander.
Ultimately, having patience can lead to investing success over time, says Walnut Creek, California-based certified financial planner Mario Hernandez.
“Not every asset is going to do well every year. Investments aren’t meant to. If you bail out and go into cash, you’ll realize that loss, and you won’t be able to participate in the rebound in the market.”
» Learn more about mutual funds, what they are and how to invest
Long-term investment vs. short-term investment examples
The difference between long-term and short-term investments is time: A long-term investment could be held for five years, 10 years, 30 years or more, whereas short-term investments might only be held in a range of a few months to a few years.
When Hernandez meets with clients, he starts by asking them about their goals and time horizon. No matter where you are on your investment journey, time is a critical factor in deciding where to place money. One of the first things to consider is how soon you want your nest egg.
“Everything you invest in is risky,” says Hernandez. “It’s a matter of perspective – less versus more risky – but in all cases there’s a level of risk.”
Generally, it’s a good idea to spread investments across a range of assets and own a range of investments within each asset class (like stocks, bonds, cash, etc.) to be diversified, thereby placing your financial eggs in a number of baskets.
“You shouldn't be invested in only one type of investment, like stocks or bonds or real estate. If you're going to plan for retirement, then you have to have enough resources and flexibility in different types of assets to know you’ll be ok and comfortable,” says Hernandez.
Money you want to access quickly, like an emergency fund, may be best stored in cash, such as in a high yield savings account or a money market account that allows your money to be readily available.
Short term investments, in contrast, act as a savings or income vehicle for an investing goal of a specified period, say one year.
Short term bond funds are considered an option for money you may need in two to three years. Composed of short-term loans to companies or governments (rather than equity), short term bond funds tend to be less risky than stocks, especially when backed by the credit of municipalities or the U.S. government.
Insured bank certificates of deposit (CDs) are considered a risk-free investment option for money you need in three to five years, as long as you don’t withdraw the money early and pay a penalty.
» Learn more about how to invest savings for short-term or long-term goals and low-risk investment options.
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Selecting a long-term investment
Considering a long term investment and not sure where to start? If your employer offers a 401(K), taking part is a great place to start, especially if they offer to match your contributions.
If you don’t have access to a 401(K) or are already contributing up to the match amount, you could consider opening and funding an IRA. Once you have an IRA or 401(K) account, increasing your contribution can be a convenient way to access the stock market.
If you don’t have access to a 401(K) or aren’t ready to open an IRA, never fear. You can still access ETFs, index funds and mutual funds through brokerage accounts, but it’s important to remember you’ll forgo the tax benefits of retirement accounts. As you consider a broker, look for one with low fees, a broad range of investments, anything that lets you set it and forget it.
» Learn more about how to open a brokerage account
As a seasoned financial expert with a background in investments, let's delve into the concepts highlighted in the article about long-term investments.
- Long-term investments are not classified as an asset class but rather an investment approach.
- Focus on seeking long-term gains despite potential short-term volatility.
- Practical definition: Holding an investment for at least a year, subject to long-term capital gains taxes upon sale according to the IRS.
- Typically involves holding for at least five years, differentiating it from short-term investments.
2. Long-term Investor Profile:
- Long-term investors take more short-term risks to achieve potential long-term returns.
- The appropriate investment strategy varies based on the investor's time horizon.
- Example: A person with 30 years until retirement might opt for diversified stocks, while someone five years away from retirement may prefer lower-risk short-term investments.
3. Long-term Investment Examples:
- Considered long-term investments due to specific tax advantages and penalties for early withdrawal.
- Examples include Individual Retirement Accounts (IRAs) and 401(K)s.
Diversified Funds (ETFs, Index Funds, Mutual Funds):
- Investing in diversified funds and holding them for the long-term is a common long-term investment strategy.
- ETFs and index funds offer exposure to the market with limited short-term volatility.
Risks and Rewards of Bond Funds:
- Bond funds, with longer maturities, could be considered long-term investments due to higher yields.
- Longer-term bonds have higher yields to compensate for the increased risk of inflation.
4. Long-term vs. Short-term Investments:
- Long-term investments held for five, ten, thirty years or more.
- Short-term investments might only be held for a few months to a few years.
- Diversification across various assets and investments within each asset class is crucial for managing risk.
- All investments carry risk; the key is to evaluate and manage risk based on individual goals and time horizons.
5. Selecting a Long-term Investment:
- Participating in a 401(K) is a great starting point, especially if the employer offers matching contributions.
Individual Retirement Accounts (IRAs):
- Opening and funding an IRA is an option for those without access to a 401(K).
- If not using retirement accounts, investors can access ETFs, index funds, and mutual funds through brokerage accounts.
- Important to consider fees and a broad range of investment options.
In conclusion, long-term investing involves a strategic mindset focused on achieving sustained growth over an extended period. Diversification, understanding risk, and selecting suitable investment vehicles are essential components of a successful long-term investment strategy.