Why You Want Longer-Term Investments

This one’s easy enough — a longer-term investment usually pays a higher return, so it’s just the kind of investment you want. Picking a long-term investment is doubly attractive when interest rates later decline, because you’ve locked in a portion of your portfolio at that higher rate of return.

Just Like Buying a House

If you have a house, you probably have (or had) a mortgage. When you were choosing your mortgage, you paid close attention to interest rates, trying to find the lowest cost of borrowing funds. You’re not alone — just listen to the countless commercials from lenders boasting about insanely low interest rates.

At some point in the decision-making process, you pondered whether to go with a fixed or a variable interest rate. You may have looked at the recent history of mortgage rates and decided that rates were the lowest they had been in several years, so it was a good idea to “lock in” a fixed rate on your mortgage.

But there are some challenges that go along with holding longer-term securities:

• Every now and then, depending on the yield curve, short-term interest rates may drift higher than long-term interest rates. At that point, you might end up with a long-term investment at 5 percent when you could have had a shorter-term investment paying 5.5 percent. Well, stuff happens — and that’s why you diversify. It doesn’t mean long-term is bad.
  
  
• What’s your definition of “long term”? To you, that may mean a year, while someone else may be thinking 30. The longest term you will typically see in operational capital is five years. In the end, you’ll find the definition of long term that matters in your investment policy, which will state the maximum term of an investment you’re allowed to take.
   
  
• Not knowing the rules can cause trouble. It makes perfect sense to think that if you purchase a longer-term investment, you’ll have to hold it for the entire duration — but you don’t. It’s possible to purchase longer-term investments and swap them for better investments as interest rates change. Trillions of dollars’ worth of bonds are bought and sold each year before they reach maturity.
  
  
• Reporting requirements can cause headaches. Government Accounting Standards Board Statement 31 (GASB 31) requires that investments with maturities longer than one year must indicate unrealized losses —those imaginary losses that would occur if you sold the investment today, but that don’t occur as long as you don’t sell. Create this kind of report and someone reviewing it is bound to misunderstand and think you lost money.

Because of these kinds of challenges, financial officers choose to keep billions if not trillions of dollars of public funds heavily concentrated in investments of under a year, when longer-term investments would be better. These officers are taking the easy road, but in doing so, they’re avoiding diversification and most often losing out on a better return.

Communication is key. If everyone understands what the challenges are and why you’re investing the way you are, the authorities to whom you report are certainly much more likely to understand. Everyone wins when you are all on the same page.