In my book, Investopoly, I outlined 8 investing rules that if followed, will help you build wealth and avoid making costly mistakes. These 8 rules are evidenced-based which I have refined over the past 20+ years.
Rule number one is; play the long game. Arguably, it’s the most important rule because I’ve observed that this is the most common mistakes investors make i.e., they don’t play the long game. Whilst this rule is simple to understand, its often very challenging to follow.
Short term profit does not create long term value
Which investment option would you prefer (you can only pick one)? Invest in an index (share) fund which will accumulate $500,000 of additional wealth over the next 10 years or follow a “stock tip” which will generate a $50,000 profit within 9 months?
Unfortunately, many investors would pick the stock tip option. They might justify their decision by planning to invest in the long-term option after they have banked a quick profit, but they rarely do. Instead, they search for the next short-term hit. To many, making a quick profit feels less risky than waiting 10+ years for a much larger gain.
Three reasons short-term opportunities are inferior
I recently came across an investment opportunity to complete a 4-townhouse development which was projected to generate between $460k to $550k in pre-tax profit (which equated to a return of between 15% and 18%). It may take 2 to 3 years to complete this development.
Of course, an alternative to this investment is to purchase a high-quality, investment-grade property and hold it for the long term. This is a better option for 3 reasons (which is why I didn’t pursue the property development).
(1) Risk-adjusted returns
Risk refers to the chance that your actual returns will vary from your expected returns i.e. that the investment doesn’t achieve what you expect. Low risk investments produce very predictable returns, such as term deposits – as the return is virtually guaranteed. An investment’s volatility rate is a good measure of its risk.
You cannot compare two investing options without also comparing their inherent risk. This is called a risk-adjusted return.
Over long periods of time, a high-quality investment property (house) should produce an average capital growth rate of at least 7% p.a. to 8% p.a. plus a net (after all expenses) rental yield of at least 1% p.a. I have previously calculated that Australian property has a historical volatility rate of circa 10%.
Property developments can present several risks including cost blowouts, failure to achieve your desired sales price due to changes in the market, adverse changes in planning rules and so on. For the sake of this example, lets apply a volatility rate of 30% (for comparison, the share market’s volatility rate is circa 20%).
The Sharpe ratio is a commonly used methodology for calculating risk-adjusted returns. A higher Sharpe ratio is better as it means you receive a high return per unit of risk.
- Development option: Return of 15% to 18% p.a., risk of 30% = Sharpe ratio of 0.48 (range is 0.43 to 0.53)
- Long-term hold: Total return of 8% to 9% p.a., risk of 10% = Sharpe ratio of 0.65 (range is 0.60 to 0.70)
This shows that the long-term hold option provides the investor with a higher return relative to its risk.
(2) Perpetual returns
The advantage of investing in assets that are expected to generate adequate returns over very long periods of time is that they benefit greatly from the power of compounding capital growth (as illustrated in this chart).
The challenge with short-term investment opportunities is you must find another equally attractive investment opportunity soon after each investment completes. This can be challenging, risky and time consuming – it’s very unlikely that you’ll be able to find an endless amount of consistently profitable opportunities.
(3) Taxes
Taxes erode wealth. Delaying taxes (such as capital gains tax) allows you to reinvest pre-tax profits to benefit from a greater amount of compounding capital growth. This is a disadvantage of short-term investment opportunities, as you must pay tax (capital gains tax) when you exit the investment, leaving you less to reinvest.
A long-term financial comparison
I have compared the two investment options above i.e. complete a $3 million property development every 3 years versus investing in a $3 million investment-grade property[1]. The chart below set out the after-tax (income and CGT) wealth in today’s dollars. It is relatively even over the first decade until compounding growth kicks in. Over 30 years, the ‘buy and hold’ option produces over 80% more wealth – over $3.2 million better off in today’s dollars. The chart eloquently proves the benefit of playing the long game.
There is one very important factor that this chart does not include. That is the amount of time these two options require. Buy and hold strategies are very ‘hands-off’ and may require just a few hours each year, on average. However, property developments can be quite time intensive including project managing, dealing with inevitable challenges, planning rules, due-diligence, feasibility studies and so on.
Why are people attracted to short-term profit?
For some investors, banking a quick profit feels less risky. Some people don’t want to wait 10 to 20 years to generate substantial equity. Earning a quick profit helps them feel like they are making progress.
Another driver is impatience. Young investors are more susceptible to this because they have a small asset base and want to build it quickly whereas seasoned investors that have already achieved a level of financial security don’t have the same sense of urgency.
A quick profit won’t change your life
Making $50,000 profit on a stock tip is a good outcome. It’s nice but it’s not going to change your life or retirement strategy. However, making the decision to invest in a high-quality, long-term investment will have a huge positive impact on your wealth, and your life.
How to play the long game
- Ask yourself; what can you invest in today that will maximise investment returns over the next 10+ years. I find 10 years is long enough to force you to focus on sound fundamentals but short enough to conceptualise.
- Resist the temptation to make a quick buck. If you do want to pursue something that’s short term, ensure it doesn’t come at the cost of compromising/delaying your long-term strategy.
- Appreciate that investments that have the fundamentals to generate good returns over very long periods of time are far better than investments that generate a once-off profit.
- Ignore all short-term noise e.g. media, spruers, etc. It’s designed to grab attention and sell advertising or product, not inform investment decisions.
Wealth transfers to the investors with most patience and discipline
We are all tempted by short term investment opportunities from time to time. That’s why it’s important to regularly remind ourselves that short-term investments do not generate long term value. It takes discipline to play the long game. Long term investments require a fair amount of delayed gratification and patience. It’s not always easy. But all the evidence demonstrates that it’s the most successful path to build wealth.
[1] Returns are risk adjusted. In development scenario each development generates a pre-tax profit of $450k in today’s dollars and after-tax profits are reinvested conservatively earning 6.5% p.a. (interestingly, the analysis was quite sensitive to this factor). Buy and hold strategy includes the after-tax cash flow cost of holding a $3 million property assuming interest rates of 5.5% p.a.
