I previously wrote about the various types of short term investments. Today I am going to discuss the various types of long term investments. As with short term investments, your time horizon plays an important role in determining whether or not you should invest short term or long term investments.
Appropriate Use of Long Term Investments
Before we get into talking about the various types of long term investments, we need to understand what exactly our time horizon is. Below is a little chart for your reference:
As you can see from the chart, if your time horizon is 5 years or less, you would be better off investing in short term investments (and reading the post linked to above). If on the other hand your time horizon is longer than 5 years, then long term investments are where you should be investing. With that said, let’s get into the various types of long term investments.
Types of Long Term Investments
Stocks: Stocks are equities and when you own a stock, you own a piece of the company. Over the long term, you can expect to earn an annual rate of return of roughly 7-8% from stocks. This is great for building long term wealth.
The problem that most investors have with stocks however, is that they allow their emotions to make decisions for them and end up buying and selling frequently. This is not ideal because as I just mentioned, stocks are for the long term. When you frequently trade, you are essentially turning them into a short term investment. When you do this, you greatly increase the chances of losing money or getting a below average return.
Mutual Funds/ETFs: Mutual funds or exchange traded funds (ETFs) are simply baskets of stocks or bonds, or a combination of the two. The reason you invest in these as opposed to stocks is two-fold.
First, it is much more cost effective as a purchaser to own a mutual fund or ETF. And second, you are instantly diversified. Combined this is great for most investors. You can invest with very little money and at the same time remove some of the risk that comes from investing too heavily in one company.
Of course, there are downsides to these investments as well, but for the average investor, mutual funds and/or ETFs are where most of your money should be invested.
Municipal Bonds: Municipalities have all sorts of projects they need to undertake. Many times they don’t have the money needed for these projects. As such, they will issue bonds to raise the cash needed and in return, pay out interest to the owner of the bond.
Typically the term for municipal bonds runs anywhere from 10 years to 30 years in duration. Because of this, they make for good long term investments. They are not ideal as a short term investment because of the length of their duration.
For example, let’s say you own a bond that pays you 4% interest. Five years later, new bonds are issued that pay 8% interest. Obviously, you want to earn 8%, not 4%, but you are locked into the 4% that your bond is paying. Your only options are to hold the bond or sell it. If you sell the bond, you will get less for the bond because the demand for it will be low. After all, who will pay full price for a bond that only earns 4% when they can get a bond that pays 8%?
Treasury Bonds: Treasury bonds are U.S. government bonds issued by the U.S. government. Because the odds of the U.S. government defaulting on its bonds are low, the interest you earn from these bonds are also low.
As with municipal bonds from above, the term of U.S. Treasury bonds is rather long – up to 30 years, and as such, they make the most sense as a long term investment.
Of course, I cannot overlook one great benefit to these bonds – their tax treatment. Since they are government bonds, you do not pay federal income tax on the interest you earn. Depending on the state you live in, the interest may be taxable though.
Inflation Protected Securities (TIPS): An inflation protected security (TIP) is also a bond. However, instead of just paying a set rate of interest, you also earn an additional interest adjustment based on inflation. Every 6 months, an inflation adjustment is made based on where inflation is.
This features allows for a reduction in the interest risk that you assume with owning bonds, but don’t expect to be earning a large interest rate overall.
Savings Bonds: Savings bonds are also long term bonds. They used to be given by grandparents to grandchildren at Christmas. However, nowadays, that isn’t very common. The term for savings bonds is 30 years, but you can redeem them before the 30 years is up. Depending on when you redeem them however, you may have to pay a penalty of 3 months interest.
Alternative Investments: Alternative investments are investments outside of stocks, bonds and real estate. They typically are made up of oil, gas and precious metals. These types of investments can be very volatile over time. Just look back to 2005-2007 as an example. Every time a hurricane or tropical storm entered into the Gulf of Mexico, the price of a barrel of oil shot up a few dollars.
Understand that when I say oil and gas, I mean the actual commodity. For companies such as Exxon or BP, they are large cap companies and you would own their stock. Therefore, they would not be included above even though they are oil and gas companies.
Real Estate: Real estate is another type of long term investments for two reasons. First, the mortgage you take out on real estate is usually 15 or 30 years in length. Additionally, selling a house isn’t very liquid. This means that if you need money, you can’t simply list your house and have cash in a day or so. It takes a decent amount of time to sell a house.
Also, the return on real estate isn’t that great. In fact, the early 2000’s was a complete anomaly. Historically, real estate prices tend to keep up with inflation, which is around 3% annually. So if you have dreams to get rich quick with real estate, you are going to very disappointed.
These are the majority of items that make up the various types of long term investments. When investing for the long term, you will earn a higher return, but this is because there is more risk involved. Don’t let this risk scare you away. If you plan on retiring or even growing your wealth, you need to invest in long term securities, particularly equities.
Most other investments, particularly short term investments will barely keep up with inflation. While you aren’t losing any money you aren’t gaining any either. In other words, you are maintaining your standard of living. That isn’t going to help you when you retire and need money to survive.
Make sure you conduct some brief research before committing to any large investments. There are a plethora of websites to choose from, but Trends Investing is an excellent starting point. This site utilizes a unique algorithm that analyzes trends in the stock market. Keep in mind that there is no way to predict the direction of any particular market, but looking into some recent trends can give you a greater understanding of how reliable certain markets may be. If anything, it will help show you the risks involved and potentially serve as an inspiration for that long term investment.