Take a long aim: It pays to be invested for years

With volatility becoming the order of the day and the likelihood of a global recession casting an ominous shadow, the need for safe investment of funds is more urgent than ever. The biggest question that pops up is: Where do we safely park funds, with near-risk-free returns and what are the options for short and long-term investments? Even in the best of times when the going is relatively good, the answer to all the above questions is: Diversify. Diversify investment horizon and diversify across asset classes. Any investment done for up to a period of three years is considered short term, and longer than the three-year threshold is considered long term.

Paul Samuelson, considered the master of modern economics, has this pithy statement: “If you don’t diversify, you’re putting yourself in the same position as the barbell: All weight on one end.” Doing that is going to hurt badly. In investments, diversification is the foundation for a good investment experience. As has been discussed, diversification is preferred in terms of time -- long term and short term -- and in terms of asset classes too.

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Short-term investments refer to investments held for a period shorter than three years. They are usually considered less risky and provide a lower potential return than long-term investments. Some short-term investment options include: Certificates of deposit (CDs), treasury bills, money market funds, short-term bond funds, and short-term fixed deposits.

On the other hand, long-term investments usually carry a higher level of risk. At the same time, they do have a potential of raking in higher returns over time. A few long-term investment options include: Stocks, long-term bonds, real estate, equities, hybrid mutual funds, and exchange-traded equity funds (ETFs).

What are the guiding factors in deciding on short or long-term investments? It almost always depends on your current financial situation, goals, risk tolerance and when the person may need money.

When you must make a long-term investment, what is the basic criterion? How does one do the math and calculate the investible surplus? Thumb rule suggests that any cash flow that is not needed in the next three years should be considered a long-term investment as they have a higher potential for better returns and compounding over time.

It’s more important to invest in the long term because of multiple factors: Life expectancy is increasing and that brings along with it health concerns in later years; work pressures leading to higher burnout rates and, hence, earlier retirement; and disintegration of the joint family system that takes away the cushion of support.

Asset class diversification

Since long-term investments mean higher risks, it’s essential to reduce or manage risks while staying invested for long. As risks cannot be the reason to stay away from investments, we must find ways to reduce risk associated with long-term investment. As economist Benjamin Graham says, “Successful investing is about managing risk, not avoiding it.”

Diversification is a key strategy to minimising risk by spreading investments across different types of assets, sectors and regions. Through this, you can reduce the impact of any one investment performing poorly. Here are a few reasons why diversification is important:

Risk reduction: Spread risks across different types of assets. This cuts overall risk of your portfolio because different types of assets, sectors and regions tend to perform differently in different market conditions.

Potential for higher returns: There’s potential for higher returns as different types of assets have different returns characteristics. By including a dynamic mix of assets in your portfolio, you may be able to capture more of the market’s potential returns.

Hedge against inflation: Diversification helps in hedging against inflation as different types of assets have different inflation sensitivities. For example, stocks have historically had higher returns than bonds in inflationary environments, while bonds can provide a higher income stream during a deflationary environment.

Flexibility: It also gives you the flexibility to adjust your portfolio as your needs and goals change over time.

Gold, bonds and equities behave differently in different times, driving home the point that diversification will minimise the risk factor. For instance, in 2009 and 2020 equities did not do well while gold and bonds put up a good show. However, in 2010 and 2021, the reverse happened: Equities did very well, but gold and bonds underperformed.

The takeaway is that a well-balanced portfolio would have reduced the portfolio downside as equities and gold or bonds usually – not always – alternate in good performance and this generates elbowroom for throwing up higher risk-adjusted returns.
This comes with a caveat, though: Diversification does not guarantee profits or a shield against loss. It can only reduce the probability and intensity of the loss.

The road ahead is clear: If it’s long term, make it a balanced asset allocation through diversification. Ignore short-term volatility, don’t chase short-term winners and look at the portfolio in totality. The asset class which does poorly in a year may outperform in subsequent years and vice-versa. Staying invested for long means you will emerge a winner if you overlook short-term hiccups.

Patience is a virtue in investments too. Who better than Warren Buffett to sum it up: “The financial market is a device for transferring money from the impatient to the patient.”

(The writer is the founder of Addwise Capital)