Short Term Vs Long Term Investing

Investing is essential to create wealth and beat inflation. In India, people have a tendency to save money as a contingency fund. We, Indians, like to invest mostly in bank’s fixed deposits, gold, real estate, and now stocks and mutual funds. The craze of investing in stocks and mutual funds is picking up with lots of young ones starting to invest. This leads us to a very important question – which is better short-term or long-term investing?

So, let’s figure this out with the help of two hypothetical investors – Vishal & Tarun. Vishal is an old-fashioned boring investor who likes to buy few stocks and hold on to them for some years, say 5 years. Tarun, however, is like a gunslinger who likes to get out of the stocks as soon as he books a decent profit.

Vishal invests ₹10 lacs in some stocks at the annual rate of 10 % for 30 years. Tarun, meanwhile, also invests the same amount of money and receives the same rate of return for the same duration of time but he trades his entire portfolio twice a year.

Now, Tarun has to pay 15% tax on short term capital gains every time he books his profit whereas Vishal has to pay 10% tax (LTCG) on his profits and on top of it first 1 lac rupees is exempted from the tax. (As per current tax rates in India- Source) One also has to pay brokerage commission and stamp duty every time he makes a trade. Vishal has to pay these charges only 5 times whereas Tarun will be paying these charges 59 times as he is a frequent trader. For the time being, we will ignore these charges in the calculation. 

Time to see – who bagged more: Vishal or Tarun?

After 25 years with an initial investment of ₹10 lacs, Vishal has about 91 lacs which is around 14.5 lacs more than Tarun’s investment worth of 76 lacs. At the end of 30 years, Tarun nets around 1 crore and 15 lacs while Vishal nets around 1 crore and 41 lacs. As you can see the difference in the investment has grown more than 11 lacs in just 5 years – this is the power of compounding and it will increase even more in the next years. Once we factor in those charges (transaction cost) we ignored, the difference will increase further. To match Vishal investment’s worth, Tarun needs to generate returns of around 1-2% higher and that is the true cost of frequent trading. If the returns of Vishal increase, Tarun will have to increase his returns even higher to match with his portfolio. Click here to view the calculations. 

Compounding is the 8th wonder of the world. He who understands it, earns it... He who doesn't, pays it...        - Albert Einstein

Verdict: 

Investment returns for Vishal & Tarun

This is a graphical representation of the returns accumulated by Vishal and Tarun. One important point to note is that compounding is working for them (profits are reinvested), the difference in the returns is due to the taxes paid to the government. For the first 5-6 years, there is not a significant difference as the blue line is not visible but as time progresses, the effect of taxes on compounding has increased and it is visible in the returns. Look at the slope of the line from 25 years to 30 years, Vishal's investments are increasing at a steeper pace and will continue to be steeper than that Tarun's in the later years. If the initial investment amount is less than 10 lacs, the effects of taxes on compounding can be seen early.

As it is now made very clear that investments should be a long-term commitment and the costs (both taxes and brokerage) actually add up and create an insurmountable hurdle to good returns. Frequent trading will rack up commissions and taxes that could have compounded. However, trading can be useful if you can generate higher returns (minimum 7-8 %) than long-term investor’s returns with more than two-third accuracy. Because of frequent traders, there is enough liquidity and uncertainty in the market which actually help the long-term investors to generate returns.