The case for trading 3 comments

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The buy-and-hold investor can beat the short-term trader over the long-term. True or false?

There have been many academic studies done with evidence in favour of the former. To me, it is a question of two issues: firstly, of probabilities, and secondly, of how one defines market performance.

Consider the hypothetical case where the investor has odds weighed slightly in his favour, such that he has a 51% chance of making money on his trades and 49% against. I can run a Microsoft Excel simulation based on this, with different holding periods (call it P; ie. if P is higher, the investor holds it for a longer period). Subjecting it to 10000 runs, the results are clear:

P=1 ==> 50.6% of making money over that period (theoretically, it would be 51%)
P=50 ==> 58.4%
P=1000 ==> about 100%!

The implication of the simple simulation is that if you hold long enough, you can't lose .... assuming you have a very slight advantage (of course, if one is lousy, time can't help him make money). So if one defines investment performance as not losing money (as opposed to maximising gain) then it makes sense to hold long-term. No wonder gurus like Warren Buffett advise so. Since their message reaches a wide audience, by definition everybody cannot be above-average investors; hence the imperative switches to at least ensuring less people lose money, hence the advice for holding long-term. Even if the individual is below-average, at least he won't be compounding his sub-50% probability many times through frequent trades (which would lead to even greater losses compared with holding long-term).

Consider however, the expected return. Whether the individual is holding long-term or trading short-term, the holding period return is still expected to be a function of his win/lose probability only. The simulation results below:

Win/loss probability 0.51 ==> 2% gain regardless of P (holding period)
Win/loss probability 0.60 ==> 20% gain regardless of P
Win/loss probability 0.75 ==> 50% gain regardless of P

Mathematically speaking, assuming win/lose probability remains constant (this is a key assumption), there is absolutely no advantage to holding over a long period, in terms of percentage gains. In other words, time increases your chances of winning (or at least decreases your potential losses), but does nothing for the magnitude of your gains. (Many will dispute this of course based on personal experience; I will elaborate below.)

Under such a scenario, the best thing to do is of course not to hold, but to trade with high frequency. Assuming that the investor's win/loss probability is due to his stock-picking and is not stock-specific, it makes sense for him to compound his gains ie. if his win/loss probability is 0.51, then he can compound his gains through successive trades eg. 5 trades means 1.02 X 1.02 X 1.02 X 1.02 X 1.02 = 10% gain.

As stated above, many will dispute my conclusion. The common argument is that a good stock is able to compound growth year-on-year, say 10-15%, so isn't that equivalent to my above "successive trades" compounding? Well, that is supposing one is able to find such stocks. My analysis is based on the investor's win/loss probabilities, and using that to simulate the expected period gains/losses. The focus switches, therefore, from the stock to the investor's capabilities (those really interested can e-mail me for a copy of my Excel simulation).

The critical assumption, actually, lies in the win/loss probability. There is no way to determine/verify this for the individual, except of course from past trading/investing record. Suppose, of course, that the individual views himself as having a slight advantage in the market, say 51% of winning. So he trades assiduously. What if he is actually not as good as he thinks, and that the real probability is actually 49%? He would actually be amplifying this weakness by trading, losing 10% over 5 trades for example (as per earlier example). Hence, there must be a sufficient margin of safety surrounding the individual's self-assessment of his track record: if he deems his win/loss margin to be 75%/25% (based on track record) en-route to his subsequent decision to trade, then a slight over-estimation of his abilities won't be so bad.

The other fact, of course, is that it is seldom that this win/loss margin can remain constant over time for the individual investor/trader. Unless, of course, the entity we are talking about is a broking firm with systematic advantage of being able to move the market with new research on its stock holdings. The market moves through cycles, not just of bull and bear but also of rotations in favour of various styles : value vs growth vs momentum, blue-chip vs small-cap, investment vs speculation. It would be unfair on the investor to expect him to retain the same margin of win/loss.

Last but certainly not least, I would see the win/loss margin over a shorter duration as smaller than that over a longer duration. Short-term, the market is efficient; day-traders are competing with the law of randomness, with no systematic advantage ie. win/loss probability is likely to be 50/50. Over a longer period, say the medium term of several months, any systematic advantage due to good analysis/insights can then begin to emerge.

Having discussed all these provisos, the bare fact remains that if one is confident that he has a certain competitive edge, he should look towards trading at a reasonable frequency rather than holding over the long-term. That is the best way to compound this advantage and translate it to monetary gains. If he feels he doesn't have it, then hold long-term lor .... and concentrate on building competitive advantages in the meantime!