Why your short-term strategy shouldn’t materially differ from your long-term one.
By: Cole Conkling
As an investment adviser, I regularly advise clients to have a long-term outlook for success. And this is very much true historically. For instance, the S&P 500 has earned a daily positive return 53% of the time—or a little better than a coin flip. Move the timeline out four months, however, and the chance of a positive return jumps to 68%. Go out a year and it’s 74%; five years, 87%; ten years, 94%; sixteen plus years, 100%.[1] Therefore, it’s very much true that the longer your investment horizon, the more likely you are to earn a positive return.
Now, one major caveat is that these probabilities are for the S&P 500 as a whole. Picking individual stocks has a much lower probability of success. Indeed, a vanishingly small number of stocks typically drive stock returns over any given period—recently, Facebook, Apple, Amazon, Netflix, Google, and Microsoft. So, if you’re a stock picker and don’t pick those winners, you’re probably earning returns well below the market—or even losing money.[2]
A lot of stock picking is necessarily short-term. Some enjoy it as entertainment and don’t have, say, a Warren Buffet-type timeline. And many don’t trade stocks to feed their family—they’re already rich! I get it. This note is not for those people. This is for the people that think they can pick stocks and quit their day job or play other get-rich-quick-games while forgoing strategies that will benefit them long term. To those people: Know that the data is against you. Take a shot, play the game, but don’t let your “shot” bankrupt you. If your goal is to have a high likelihood of making money, then read further. If your goal is entertainment, then keep pulling the slot machine lever, but know that monetary success will likely elude you.
While the data show that a longer-term horizon is best, the same successful long-term strategies can be applied in the short term too. Even, yes, the shortest of short term: Day trading. Many day traders and short-term investors wrongly believe that their strategies must materially differ from long-term ones to be successful. They want to take big risks and earn big rewards—and quickly. So, instead of holding a relatively safe index fund for a day, a day trader will buy individual stocks hoping for a pop. Or buy options and shoot the moon. But what many miss is that they can also increase their probability of success by following the same strategy as longer-term investors—namely, not trying to beat the market, but simply replicating the market.[3]
Let’s use an example to flesh this out. Say you’re flipping a coin: Heads you get a positive return; tails you get a negative return. Consequently, every time you flip the coin you have a 50:50 chance at a positive return. But we know, based on pure mathematical probability (and common experience), that coin flips don’t look like this: H-T-H-T-H-T-H. Instead, because of randomness, many coin flip iterations could look like this: H-H-H-H-H-H-T-H-H-T-; or this: T-T-T-T-T-T-T-T-T-H; or any other combination you can dream up. Thus, in the short term, you could go on an incredible winning streak—or a devastating meltdown. Either way, however, the longer you flip the coin the more the laws of probability converge to 50:50. In other words, long term, the expected probability will occur, so be prepared.[4] But—and here’s the key point—the 50:50 probability still matters in the short term. That’s because, no matter if you flip the coin once, or a thousand times, each individual flip has the same probability of 50:50.[5] It’s just that the shorter the timeframe, the more that randomness (the H-H-H-H-H-H-H-H outcome) matters.
Back to investing. The empirical evidence shows that for any time period, investing is a zero-sum game, meaning that for every trader that outperforms the market, there must be a trader that underperforms the market. The market thus reflects the average of all traders. Add in costs, fees, and taxes, and the vast majority[6] traders will underperform a given market over time based on the simple math alone.
As noted, the longer your timeframe, the higher your probability for success. But, even if your time horizon is only one day, you still have the highest probability of earning a positive return if you replicate the market as cheaply as possible. This remains true if your time horizon is two days, a week, a year, a decade, or a lifetime. It’s just that the shorter the timeframe, the less chance you’ll realize the expected positive return. But stick with it long enough, and the odds turn heavily in your favor.
So, if you’re a short-term investor, you’d be better off investing in the market (via a low-cost index fund) over any other strategy. And, if you want more return than an index fund can reasonably provide over the short term, your best bet is to simply use leverage. Leverage is understandably a scary word to many investors, and rightly so. However, when used properly and responsibly, leverage can be a formidable tool to increase risk and return in the short (and long) term, assuming it’s being applied to relatively safe assets (i.e., a well-balanced, market portfolio and not individual stocks).
The takeaway here is that the empirical evidence shows that the strategy that gives an investor the highest probability of a positive return is the same no matter if your time horizon is one day or one lifetime. And while a shorter time horizon will lower the probability of earning a positive return, this should not affect your strategy. Finally, if you want to have a chance at earning high returns in the short term, the strategy with the highest probability of success is to leverage a broadly diversified market portfolio.[7]
[1] This data is based on the historical frequency of positive S&P 500 returns. Each listed timeframe is calculated using monthly rolling holding periods from 01/31/1926 to 12/31/2017.
[2] Between 1926-2016, the top 50 stocks accounted for 40% of total market returns; and five companies (Apple, ExxonMobil, Microsoft, GE, and IBM) accounted for 10% of all created shareholder wealth. Over 50% of the stocks listed in America in the past 90 years were worse investments than U.S. Treasury Bills. Picking stocks is truly a loser’s game.
[3] While the “market” I’m referring to here is the S&P 500, there are of course numerous markets where this is also true (e.g., small cap stocks, international stocks, bonds, and commodities).
[4] Casinos are keenly aware of the laws of probability.
[5] As with any analogy, this one isn’t perfect since, as noted above, the longer you invest (in the right things) the higher the probability of a positive return. Alas, time horizons do matter. The point is that the longer your timeline (whether you’re flipping coins or investing) the more the expected probability (50:50 for coin flips; increasingly positive returns for investing in the S&P) will materialize.
[6] Eugene Fama, the “father of modern finance” and a Nobel laureate, has found that 97% of active traders (including professional managers) will not outperform their respective market over the long term.
[7] Unless you are supremely well versed in the use of leverage, this strategy should, in most instances, be implemented and managed by a professional with experience using leverage.
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The information provided is for educational and informational purposes only and does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor's particular investment objectives, strategies, tax status, or investment horizon. The views expressed in this commentary are subject to change based on market and other conditions.