Long-Term Investors Should Buy Equities - Literature review Example

LONG-TERM INVESTORS SHOULD BUY EQUITIES by Student’s Name Code + Course Name Professor University City/State Date Long-term Investors Should Buy Equities Introduction Trading in equities is one of the most lucrative types of modern investment. Since the inception of the concept, organizations as well as individuals have reaped good financial returns on their investments. For this reason, it is almost obvious why there have been numerous discussions on the nature of equity investment and its role in creating wealth to individuals. In spite of the potential benefits, investment in equities is still regarded with suspicion and fear of loss. According to Singhania and Chabria (2013, p.5), speculation and desire for instant gratification are some of the reasons why people still regard investment in stocks with suspicion. The truth of the matter is that investing in stocks carries with it a certain degree risk. The element of risk is normal. It is a characteristic of the process of wealth creation. Therefore, long-term investors should not be afraid of investing in equities. In fact, long-term investors should go for it. A look at the history of trade in equities will demonstrate that it is one of the profitable ways of investing. On the other hand, a review of types of equities and stock options is expected to show that long-term investment in the right type of equity can be beneficial to long-term investors. In addition, a discussion on investment theories is expected to illustrate that long-term investment in equities is the way to go for long-term investors. Lastly, there will be a discussion on the benefits of investing in long-term equities. The History of Equity Trading The history of stock trades goes as far as the early 1800s. At that time, the system was not as structured as it is. Nonetheless, the concept was in place and individuals put in their moneys into privately held companies with the objective of getting a return. The equity trade as we know it today only became popular after the Second World War when more corporations and wealthy individuals began participating in this type of trade. Today, the stock market is well defined, structured, and even regulated. It is a better trading environment than what it was more than a hundred years ago. The management and structure of equity trading have changed over time, but the concept has remained the same. Individuals or corporations purchase a stake in a business entity and become shareholders. This concept is better captured by under the definition of equity. According to OECD (2008, p.181) equity refers to either partial ownership of an asset or the value of interest in a company. The term equity has also been used interchangeably with stocks. A look at the history of trading at the stock markets reveals that from 1802 to up to date, returns on equity investment is greater than of all other assets (Sigel 2008, p.6). Despite the various market shocks, equity investments have weathered different market shocks to become the most profitable investment of all time. Siegel (2008, p.5) notes that every invested and reinvested dollar since 1802 on stock options of companies surviving up to date would be valued at $ 12.7 million in 2006. Nonetheless, it is important to put this value into a present day perspective. A comparison of the purchasing power of money shows that in 1802, the value of $1 million is equivalent to $ 16.84million (Siegel 2008, p.7). The diminishing value is attributed to the fact that it is almost impossible for any person to accumulate wealth over such a long period without consuming part of its returns. Nevertheless, the stated figures demonstrate the power of long-term investment in the stock market. It is factually clear that long-term investors with the patience and endurance can create immense wealth for their long-term investment goals or beneficiaries. Investment Theories It is a fact that some long-term investment decisions can lead to long-term accumulation of wealth. Financial experts have been able to demonstrate that investing in the right stock options can result in profitable returns over time. Behavioral finance is one of the disciplines that seek to explain how investors make their decisions (Reilly & Brown 2012, p.169). It looks at how psychology, social psychology, and neuro-finance affects the way investors makes choices. The discipline offers various theories and assumptions that explain the factors that influence short or long-term investment. Based on behavioral finance science knowledge, long-term investors can be described as fusion investors. They consider personal sentiments, fundamental investment valuations when making decisions. Consequently, their decisions are well informed and are likely to succeed in making good long-term investment decisions. The different hypothesis propagated by behavioral finance appear to imply that investors with fusion like investing characteristics should consider long-term investing as opposed to short term. They are likely to make better long-term investment decisions because of their behavioral disposition. The estimated expected return is an approach that is used to determine the future value of equity in the investment. The approach draws its conclusions from the analysis of long-term historical performance data of an asset class. The estimated expected approach is founded a theory that the correlated amount of investment with market conditions and time. Elton et al.(2010,212) note that this approach has been used to calculate the investment returns for US companies from as early as 1926 to date. This method compares stocks against Treasury bills performance. Based on its estimates, large and small company stocks had better return on investments at 8.8% and 11.3% respectively for the duration of 1995 to 2007 (Edwin et al. 2010, p.212). Baker and Filbert (2013, p.108) point out that optimal portfolio models can be linked to human wealth. This approach takes into account the different life stages of an individual and amount of wealth at that time. Their analysis demonstrates an investment theory that considers a person’s non-portfolio wealth, which they refer to as human wealth against portfolio wealth such as equities. According to this model, individuals with low-risk tolerance are likely to grow their stocks at a steady rate over long periods. A 0.25 correlation between human wealth and stock means that moderate risk tolerance persons are advised to allocate 60% of their investment portfolio towards stocks at the age of thirty and steadily reduce it to 35% by the time they turn 60 years (Baker & Filbert 2013, p.109). This analysis shows that strategic long-term investments in equities are an effective strategy that will secure future source of income, especially after retirement. These investment models, approaches, and theories demonstrate that personal attributes influence long-term investment. Therefore, long-term investors should buy equities since they are likely to meet their investment goals. The theories also exhibit that most long-term investors prefer low-risk investments that can almost guaranteed of returns over time. Types of Equities and their impact on Long-term Investment Common stock is the most familiar type of equity to many investors. It represents an ownership to a company. Many investors purchase common stocks for short-term speculative purposes, dividends returns, or long-term financial security. According to Smith (2011, p.23) common stocks are good long-term investments because their value is determined by its earning power. In addition, this type of investment is driven by economic factors. Therefore, a good economic fortune almost guarantees good returns on investment. A broad common stock investment portfolio has been known to result in better return margins compared to other investing instruments in the securities markets. Having a diversified stock portfolio helps to spread out risks. Although stocks are highly volatile, its prices can be leveraged on different factors including its earnings. This in turn means that despite prevailing hostile economic conditions, stock prices can be sustained by strong market fundamentals even when speculative practices threaten to weaken the prices. This aspect makes common stocks a good type of long-term equity investment. Preferred stocks are another type of equity investment although not as popular as common stocks. Investing in this type of equity guarantees the investor of fixed amount of dividend. This type of investment is particularly good for individuals who are looking for a steady flow of income in the form of dividends. The yields may be lower compared to common stocks, but the security of returns is one of the factors that makes this type of stocks a good long-term investment. Long-term investors also can invest in growth stocks. According to Kiplinger’s (2005, p.3), the rate of return on growth stocks can rise faster than the rate of growth of the economy or that of the stock market itself. This type of stocks has high earnings. They are also expected to generate capital returns over long periods. Some factors make investments in equities better than bonds or other debt instruments. Therefore, long-term investors purchasing growth stocks are almost assured of impressive yields. Blue chip stocks are stocks are equities offered by leading industry companies. Ernst& Young LLP, Nissenbaum and Raasch (2004, p.79) note that blue chip stock companies pay out dividends no matter the performance of the company. This type of stock represents consistency and security of investments due to the regular dividend payout to shareholders. The stocks also have consistent growth rates compared to other types of stocks. For long-term investors, this kind of equity can be held for a lifetime and bear low-to- moderate risk. Ernst & Young LLP, Nissenbaum and Raasch (2004, p.79) assert that blue chip stocks are attractive long-term investments. Income stocks are another attractive equity investment for long-term investors. Ernst & Young LLP, Nissenbaum, and Raasch (2004, p.79) state that income stocks have a history of paying high dividends. This assertion is good news for long-term investors since one of their investment goals is to secure consistent and high returns in the future. The stocks are also suitable for long-term investors who have an appetite for risk, especially because they are highly sensitive to interest rate fluctuations. Income stock is suitable for long-term investment purposes because they provide current cash flow to investors. The amount of cash received depends on the number of shares and the authorized dividend payout amount. Stock Options Investors have the right to decide when they can sell their shares. This right is recognized in an arrangement referred to as a stock option. A stock option is an agreement between the share buyer and its contracted reseller to purchase or sell stock at a preferred price before on a given date. Long-term investors can make such arrangements with their stock brokerage as one to the strategies to cushion themselves from losses and increase their probability of greater margins (Ayres & Nalebuff 2008, p.3). Stockbrokers can make investment decisions on behalf of their clients depending on the type of option they have requested. An option in the context of stocks refers to the instructions a client delivers to his broker. When an investor gives a call option, it means that he or she has given the broker the right to purchase equity. Call options is a good strategy for building up a diversified stock portfolio. On the other hand, investors may also have a put option. Put options allow investors to sell an equity at a specific price and a specific time. Like call options, put options are an effective way of managing broad portfolio since it allows investors to get either get rid of non-performing stocks or reap the short term gains of bull running equities for reinvestment In better stocks. One of the advantages of trading using options is that it provides long-term investors with both a versatile and flexible tool. These attributes are attributed to the structure of stock options. These contracts are designed to take advantage of speculative practices in the market hence allowing investors to reap maximum benefits. Its versatility prepares long-term investors to purchase cheaply priced equities as a long-term strategy that will enable them to position themselves for greater market shifts that they may not be aware of at the time of the purchase. Banker, Huang and Natarajan (2013, p.108) note that stock options offer incentives to managers to manage company stocks in a manner that promotes input resource expenditure rather than control or reduce it. The long-term is value creation for both the managers and shareholders. In addition, options have been associated management of retirement funds. According to Ayres and Nalebuff (2008, p.3), stock options can cushion long-term investors from retirement risks. Besides its risk protection advantages, stock options can also be used as a borrowing tool. Long-term investors can choose to take out loans and use their equities as security. This dual ability provides investors with an opportunity to benefit from the present and long-term value potentials of the equity. Ayers and Nalebuff (2008, p.8) point out that a young investor who invests $10000 and their portfolio is expected to be worth $100000 at the time of their retirement can take out a loan at a ratio of 2:1. These figures reveal that long-term investors can strategically position themselves to grow not only their portfolio for future gains but also to finance their immediate cash flow needs. Advantages of Investing In Long-term Equities Investing in long-term equities provides long-term investors with a chance to exploit the opportunities created by short-term investors (Warren 2014, p.4). This is can be attributed to the fact that long-term investors are likely to have a broader opportunity set compared to short term investors. Their ability to stick through different market conditions rewards them with higher reward potentials compared to short-term investors. It is a classic scenario of high-risk, high returns. Long-term investment in equities provides the investor with numerous benefits. One of the benefits relates to their capacity to position themselves strategically to take advantage of uncertainties in pricing. Another advantage stems from their ability to take advantage of opportunities generated by market speculators and lastly their increased ability to invest in diverse types of equity (Warren 2014, p.8). Long-term investors are visionary and can insulate themselves from market noise and uncertainties. The choice to focus on long-term price changes as opposed to short-term gains enables them to stay away from investing in attractive stocks that cannot withstand immediate market shocks or adjust quickly to market price adjustments. Long-term investors are successful because of their capacity to hold to their positions regardless of the immediate returns realized. This attitude restrains them from reacting to behavioral or organizational pressures when short-term losses are incurred. In the end, they are likely to benefit from price earning realized over times. Mispricing is one the resultant effects of short-term investments. According to Warren (2014, p.9), mispricing creates a value gap between the current price and future potential price. The presence of such a gap facilitates for a long-term investor divergent needs. The pricing errors can support discretion trading as well as provide them with a chance to benefit from the opportunities that are likely to arise from the risk transfer. Long-term investors are also likely to benefit from capital gains. According to Precision Information LLC (2014), long-term investors benefit from tax advantages such as lower tax rates that are lower than the investor’s income tax bracket. Concerning trading expenses, long-term investment offers lower transaction costs compared to short term trading. Investors can avoid incurring certain sales charges if they hold to their stock for long periods. Conclusion This paper has discussed some of the factors and reasons that would make long-term investors consider investing in equities. Based on the information and available literature, it is evident that equities are the most reliable form of investment. An analysis of historical performance of equities in the stock market illustrates that they are the most resilient form of equity. Their potential to create wealth cannot be underestimated. Different investment theories, models and approaches all draw the same conclusion regarding investment in equities. They all reveal that long-term investment can lead to good future returns depending on an individual's investment portfolio. Therefore, long-term investors are encouraged to have broad portfolios. The theories conceive diverse range of equities as the best strategy to mitigate the risk of loss. They also illustrate how an individual's financial behavior, age and time factors if well managed can lead to good investment returns over time. The models provide empirical evidence that a long-term investment in equities is a sustainable method of amassing wealth over time. Consequently, long-term investors should consider investing in equities. Different types of stocks are characterized by different rates of returns. For instance, blue chip stocks are associated with high and regular dividend payouts. Long-term investors looking to invest in equities need to align their investment goals with the types of stocks. The discussion has shown that long-term investors interested in having a future cash flow in the form of dividends are more likely to invest in income stocks because they promise current capital flows. Cautious investors who would not like to lose any money can invest in preferred stocks as they offer security against loss and regular income as well. This study has managed to offer a multi-perspective point of view on why long-term investors should invest in equities. A look at the history and current developments has shown that changes have promoted innovative ways of trading among them stock options. The existence of a contractual obligation to execute an investor's wishes is a sign that individuals have control over their investments. In addition, it is clear that long-term investment have dual properties. Besides securing future income, they can be used to finance present projects or other investments. This property demonstrates long-term investment in equities does not lock up capital rather it provides investors with unique ways of utilizing their money. This discussion has managed to point out some of the factors and reasons that should make long-term investors invest in equities. Reference List Singhania, A & Chabria, Y 2013, Investing in equities and assets that create wealth, Network 18 Publications Ltd, India Ayres, I & Nalebuff, BJ 2008, ‘Life-cycle investing and leverage: buying stock on margin can reduce retirement risk’, NBER Working Paper, vol. w14094, no.1, pp. 1-5. Baker, HK & Filbeck, G 2013, Portfolio theory and management, Oxford University Press, New York Elton, EJ 2010, Modern portfolio theory and investment analysis, Wiley & Sons, Hoboken, NJ, J. Kiplinger 2005, The basics of investing in stocks, Kiplinger's Personal Finance, Washington LLP, E & Nissenbaum, M & Raasch, BJ 2004, Ernst & Young's personal financial planning guide, John Wiley & Sons, Hoboken. Organization For Economic Co-Operation And Development 2008, OECD glossary of statistical terms, Available at: http://site.ebrary.com/id/10251720 [Accessed on 18 February 2015] Precision Information LLC 2014, Benefits of long-term investing, Available at: http://www.calcxml.com/do/article?id=-6630033&cat=saving, [Accessed on 18 February 2015] Reilly, FK & Brown, KC 2012, Investment analysis and portfolio management, South-Western Cengage Learning, Mason, Ohio Siegel, JJ 2008, Stocks for the long run: the definitive guide to financial market returns and long-term investment strategies, McGraw-Hill, New York, Smith, EL 2011, Common stocks as long-term investments, [Whitefish, Mt.], Kessinger, p.23 Warren, G 2014, ‘Benefits (and Pitfalls) of long-term investing’, CIFR Paper, vol. 40, no.1, pp. 4-9. Read More