What Are Some Characteristics Of Short-term Investments? Check All That Apply.

Andrew is a self-educated business owner and entrepreneur with plenty of free advice (which is worth exactly what you pay for it!).

Just because you're a long-term value investor doesn't mean you can't also trade individual stocks in the short term.

The Reality of Compounding

One of the first things that get investors excited is understanding the power of compounding—the ability for money to grow itself by collecting interest or dividends, then allowing the interest or dividends to grow, spawning even more cash.

This point is driven home again and again by great investors with long-term horizons like Warren Buffett, Monish Pabrai, and Seth Klarman through their letters to shareholders and in various interviews over the years. It's true; you're almost guaranteed to lose out on the long-term gains of the market if you're staying out of it and trying to wait for a crash to jump in.

However, it's also important to view the totality of available stock investments out there as a market of stocks—not a stock market. This means that we're not concerned whether the S&P 500 is at an all-time high right now; we're concerned about whether a particular company is on sale (selling for less than its intrinsic value) or not.

Just because times seem exuberant (and therefore risky since companies are generally expensive) doesn't mean that every single one of the thousands of publicly traded companies is currently expensive. In fact, I can almost guarantee that there are plenty of great deals out there; it's just a matter of how tough it can be to find them.

The Myth of Compounding

While it's necessary to stay invested in some capacity most of the time in order to reap the rewards Mr. Market has to offer, there are actually two very different ways to go about this. First, you can buy and hold stocks for Buffett's favorite holding period: forever.

This means that the business you own will continue to put your money to work over time, and if you're reinvesting any dividends, the business is also going to try to compound that money as well. It's a great scenario if you can find a company that triples in value in a decade or so, and companies like these aren't impossible to find. The conventional wisdom has become "buy and hold so you reap the benefits of compounding."

However, there's another way forward. If you sell a stock at a profit, as Ben Graham, the father of value investing, did throughout his career as he was writing The Intelligent Investor, you don't have to go and hide under a rock or something until the market crashes. Instead, you can sell an overpriced security and then find an underpriced one in which you can reinvest immediately, staying in the market almost the entire time.

One way to ensure this can happen (so you don't get stuck holding a bunch of cash for a really long time) is to identify a replacement stock before you sell the overpriced stock. Alternatively, it might work out better for you to take the profits and just hold the cash so you can wait for a better option, but you have to be careful not to simply stay out of the market with that cash forever.

A Wife or a Harem?

Another fantastic Buffettism is the analogy that buy-and-hold investing is like having a wife, whereas trading dozens of stocks is like having a harem. The point here is that knowing about a small handful of companies makes it far easier to track their movements, and we already know that the case for a long-term horizon is strong.

Imagine traveling with a band of explorers across uncharted territory in the valley of a mountain range. You're carrying around a boat that only one person can fit in. The boat is light; it's made of a polymer or something, so it's pretty easy to carry, but the friends you're traveling with are moving across the terrain much faster than you are.

Then it starts raining like there's no tomorrow, with water levels starting to rise up above your knees and then to your waist. You get into your boat and continue traveling forward, leaving the other explorers trying to slough through the waist-deep water far, far behind you.

Similarly, remaining contrarian while the skies are sunny out there and slowing down your own performance down while other people are "YOLOing" their way to seeming riches can be emotionally challenging, but that boat sure does come in handy when you need it, and minimizing the downside tends to take care of the upside in the long term.

Buffett's "wife vs. harem" analogy is certainly valid when it comes to understanding what you're investing in, but Peter Lynch famously had hundreds of stocks in his incredibly successful Magellan Fund, and other value investors with shorter-term horizons for individual stocks (like Seth Klarman) have performed incredibly well by reinvesting the cash from the sale of overpriced stocks (or, in Klarman's case, stocks that approach fair value).

The best hedge fund in history, the Medallion Fund (managed by Renaissance and crafted by Jim Simons), continues to turn its stocks over with incredible frequency. What all of these approaches have in common, though, is that they're all trying to stay in the market all the time—not to stay out of it for any macroeconomic or arbitrary reason. It's all about whether you can find individual deals.

Trading and Investing Simultaneously

One huge advantage I hope you can walk away with here is flexibility. What this means is that you can view your horizon when buying a stock as forever, feeling comfortable enough owning stock even if the market were to shut down for ten years.

If your assumption is that the underlying business is strong and likely to grow and make money over time, who cares what the short-term price is? You can just hold onto that sucker forever, ultimately collecting dividends in retirement, or you can sell in in a couple of decades if you need the money, long after the stock has (hopefully) appreciated many times over.

On the other hand, if you own a stock that you like but that the market seems to think is worth even more than you think it is, it might work better for you to sell that stock, especially if you can buy another one to replace it almost immediately. If you can't find a good replacement, perhaps holding onto the overpriced one is a good idea, or maybe it's better to sell it while the market has gone crazy; that's going to have to be a personal judgment call I can't make for you.

On the flip side, if you're comfortable owning something for a really long time, this can help you be much more stoic during market downturns (or if a stock price has gone down for no apparent reason). In other words, you are neither obligated to sell, nor do you have to hold any time soon. If you can master the change in mindset between "hold forever" and "take profits," you can have a significant advantage over someone who only does one or the other.

This article is accurate and true to the best of the author's knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.