Financial goals exist on a timeline that stretches from a few months to years into the future. Some financial goals, like buying a new car, might occur within a year. Others, like retirement, may be decades away. Fortunately, different types of investments can help you achieve these short- and long-term goals.
Here’s a look at long- and short-term investments and some of the important considerations that come with each. Knowing the difference between long- and short-term investments can help you build a portfolio to achieve your financial goals.
What Is a Long-Term Investment?
A long-term investment is an asset or security expected to generate income or appreciate in value over a prolonged period, typically five years or more. However, for tax purposes, the Internal Revenue Service (IRS) considers long-term investments to be investments held for more than a year.
Long-term investments often gain value slowly, weathering short- to medium-term fluctuations in the market.
Investors usually build long-term investments into balanced portfolios that consider their goals, risk tolerance, and time horizon. Usually, investors hold these investments for a few years or more to help fund long-term goals, like retirement or saving for a child’s college education.
Any investment can be a long-term investment, but the foundation of a long-term investment portfolio is typically a mix of stocks, bonds, mutual funds, and exchange-traded funds (ETFs). Long-term portfolios may hold other assets, such as real estate.
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What Is a Short-Term Investment?
Short-term investments are assets that investors hold for less than five years. Investors typically use these investments to help fund short-term financial goals, such as saving three to six months’ worth of expenses in an emergency fund, saving to buy a new car, or saving for the down payment on a home.
Investors can hold almost any investment in the short term, including stocks, bonds, and ETFs. Many investors trade these assets in short periods, like days, weeks, and months, to profit from short-term price movements.
However, these assets can be risky and volatile, resulting in losses in a short period. Therefore, investors consider less risky investments, such as certificates of deposit (CDs), high-yield savings accounts, or short-term bonds, if they want to invest in assets that will provide stable returns in a short period.
While these investments may not offer the potentially higher returns of investing in the stock market for the long term, they make it more likely an investor’s money will be there when they need it in the short term.
In fact, certificates of deposit and high-yield savings accounts are FDIC insured for up to $250,000.
Long-Term and Short-Term Investments: The Differences
As mentioned above, long-term and short-term investments have several differences. For example, investors typically buy long-term investments to hold for many years, only selling the assets when they need the funds. In contrast, investors usually make short-term investments to get a return within a period as short as a day and as long as three years.
Another difference is that long-term investments like stocks are often volatile, whereas short-term investments like certificates of deposit or high-yield savings accounts provide stable returns.
Additionally, the IRS taxes the gains on long-term and short-term investments at different capital gains tax rates.
Long-Term and Short-Term Investments: The Similarities
Investors use both long-term and short-term investments to grow wealth, which is the main similarity between the two types of investments.
Additionally, long-term and short-term investments involve some degree of risk; there are no guarantees with any investments.
What About Day Trading?
As mentioned above, some investors trade assets, like stocks, ETFs, and options, in short time frames to profit from volatile price movements.
Day trading is a style of this short-term investing, where investors hope to buy and sell a stock for a modest profit, usually within the same day. By nature, day traders are exploiting volatility in the stock market. As stock prices fluctuate throughout the day, they hope to capitalize on upswings, buying low and selling slightly higher.
While it may sound exciting, day trading is not appropriate for most investors. That’s because the profits for day trades can be relatively small, and investment fees and taxes can eat into even those modest profits.
While investors can turn a profit by day trading, it’s equally likely that they will lose money.
What’s more, day traders are competing with professionals who have lots of sophisticated tools and information at their disposal to help them succeed. These professionals are often moving large sums of money and attempting to turn a profit on tiny gains. Even these experts fail to time the market much of the time.
Long-Term Investing and Compounding Interest
Compound interest is one of the more powerful tools available to investors. It is why even seemingly small amounts invested today can go a long way in the future.
The idea is simple: investments hopefully earn returns, and when those returns are reinvested, they also start to earn returns. As a result, investor savings can grow at an exponential rate.
To get a clearer idea of how this works, investors can use a compound interest calculator to input various starting investment amounts, regular contributions, and interest rates.
While compounding interest begins to work its magic as soon as an investor starts to invest, the benefits are long-term in nature. The longer the investor can allow their returns to compound, the more money they may be able to make.
As a result, investors may want to consider compounding as more a part of a long-term investment strategy than a short-term strategy.
Tax Differences Between Long- and Short-Term Investments
The federal government charges different capital gains tax rates on investment profits depending on how long an individual holds their investments.
Investments sold after more than a year are subject to the current long-term capital gains rate, which is equal to 0%, 15%, or 20%, depending on an investor’s income and the type of investment.
The long-term capital gains rate might be much less than their income tax rate, which can help incentivize investors to hang on to their investments over the long run.
Investments sold in a year or less are subject to short-term capital gains. The short-term capital gains are taxed as regular income and are determined by an investor’s tax bracket.
Investors considering short-term investments of less than a year should be sure to factor in the cost of paying the higher short-term capital gains tax rate.
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Capital Gains Tax Rates
Long-Term Capital Gains Tax Rates for 2021-2022
|Tax Rate||Single||Married Filing Jointly||Married Filing Separately||Head of Household|
|Source: Internal Revenue Service|
Short-Term Capital Gains and Income Tax Rates for 2021-2022
|Tax Rate||Single||Married Filing Jointly||Married Filing Separately||Head of Household|
|Source: Internal Revenue Service|
Finding the Right Approach
Whether an investment is meant for the short or long term can significantly impact whether an investor chooses an active or passive investment strategy.
Active Investing for Short Term Goals
Active investing is a hands-on investment approach and often goes with a short-term investment strategy, like day trading.
Active investing might mean hiring an investment manager who will handpick investments, buying and selling them in a short time frame to beat the market. Because of their active involvement, these managers often charge relatively high fees.
Individual investors may also pursue this strategy, choosing investments and deciding when to buy and sell. This approach can be much cheaper than hiring a professional.
An active strategy may work well for an individual saving for a near-term goal who wants the flexibility of being able to choose specific financial instruments, such as short-term bonds, to help them save.
However, an active investing strategy to make short-term gains is risky and not appropriate for all investors.
Passive Investing for Long Term Holding
Passive investing is a relatively hands-off strategy in which investors attempt to match the movement of a market index, often by using mutual funds, ETFs, or index funds.
For example, some funds might track the S&P 500, owning all of the companies tracked by that index at the same proportion and percentages they make up there.
Passive investments are not necessarily trying to capitalize on short-term movements in the market. Instead, they are trying to track the market over the long run. Passive investment strategies often come with low or no fees.
Any index is likely to experience ups and downs. Investors taking a long-term approach may have time to ride out rocky patches.
Holding Short-Term vs Long-Term Investments
Investment time horizon can also play an important role in where an investor holds their investments. Invests can open short-term investments such as CDs and high-yield savings accounts with a bank.
Short-term investors will need to open a brokerage account to trade stocks and other securities. Investors can place orders to buy and sell stocks and bonds online or by phone through a broker.
Brokerage accounts are taxable, meaning that any gains an investor makes are subject to capital gains taxes. Investors can sell securities and withdraw their funds at any time.
Long-term investors may want to consider several investment accounts, including a brokerage account, to help meet their long-term goals.
Long Term Investing with a 529 Plan
An investor saving for a child’s college education might consider a tax-advantaged 529 savings plan. Parents, as well as extended family and friends, can contribute to 529 plans. Funds inside the account can then be invested in various investments, including mutual funds and exchange-traded funds.
Investments grow tax-free inside a 529 account and are not subject to capital gains tax. Withdrawals from the account are also tax-free as long as they are used to cover qualified education expenses, such as tuition, room and board, fees, and books.
Withdrawing the money for other reasons can subject investors to income tax and a 10% penalty on earnings.
Long Term Investing with a 401(k)
Retirement is perhaps the ultimate long-term goal for many investors. The government is very interested in incentivizing you to save for this period of your life, so they provide many different options for savings accounts, including employer-sponsored 401(k)s.
Traditional 401(k)s are employer-sponsored plans that allow eligible employees to set aside a portion of their pre-tax paycheck into an investment account. They can usually invest their funds in a limited suite of investment options, such as mutual or target-date funds.
Investments grow tax-deferred, which can supercharge growth when combined with the power of compounding interest.
After age 59 ½, investors can make withdrawals, which are subject to income tax. Withdrawals before that age are subject to income tax and a 10% penalty, although there are some exceptions to that rule.
Retirement Options other than a 401(k)
Workers who don’t have access to a 401(k) – or those who do and want to save more – may want to consider a traditional or Roth IRA to invest in for retirement. Investors can fund traditional and Roth IRAs up to certain limits and invest the money however they want.
Traditional IRAs are funded with pre-tax money. Funds grow tax deferred and are subject to income tax once withdrawn after age 59 ½. As with 401(k)s, withdrawals made before this point are subject to income tax and a 10% penalty.
Roth IRAs, on the other hand, are funded with after-tax dollars. Investments inside these accounts grow tax-free and are not subject to income tax once withdrawn after age 59 ½.
Each of these retirement accounts potentially ties up investors’ money for decades, and early withdrawals are subject to stiff penalties. They should be considered chiefly as long-term investment tools.
Deciding Between Short-Term vs Long-Term Investments
A mix of long- and short-term investments can lead to a diversified portfolio that can help investors achieve financial goals. This is especially true if you invest in long-term assets, like stocks and ETFs, for retirement or long-term savings. You can use short-term investments, like CDs or a money market account, to fund a vacation or build up an emergency fund.
However, if you are looking to make short-term profits through trading securities like stocks, ETFs, or options, you have to make sure you have the risk tolerance and time to take on this strategy. Most financial experts do not recommend that investors take on this strategy.
Start Investing With SoFi
If you’re ready to start saving for short- or long-term goals, consider the SoFi Invest® online investment platform. The Active Investing feature allows investors to choose stocks, ETFs or fractional shares to buy. For a limited time, funding an account gives you the opportunity to win up to $1,000 in the stock of your choice. All you have to do is open and fund a SoFi Invest account.
What are the differences between long-term and short-term investments?
The main difference between long-term and short-term investments is the time each type of investment is held. Long-term investments are held for years, while short-term investments are held for days, weeks, months, or a few years. Additionally, long-term investments take longer to mature and have more risk, while many short-term investments are often less risky.
What are the similarities between long-term and short-term investments?
The similarities between long-term and short-term investments are that they are both types of investments, and they both have the potential to help investors build wealth.
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