The graphic below is a visual model for the divergence that exists between real, actual investor time horizons, and perceived, or “idealized” time horizons.
While the above graphic could use some refinement, it contains several powerful trading and investing concepts.
Most market participants want to believe they are “investing for the long term”. Yet when push comes to shove, Short term gyrations guide investor behavior more than any other factor. This has been proven by DALBAR’s quantitative analysis of investor behavior.
What goes wrong? I think it is something like this: Long term investors are shaken out of positions with losses, and then miss the subsequent rise. After a rise, the investor buys in again because it feels “safe” after recently strong performance. Notice that this behavior is the exact opposite of what a true “long term investor” would be doing.
The same principle also applies to traders. If you conduct analysis using a daily time horizon, being overly concerned with intraday price action can be very destructive to your results. Your historical analysis should encompass the activity which occurs within a one day time period. If you can’t stand the pain of intraday volatility, then you can’t realistically expect to trade the strategy for a profit.
A successful long-term value investor makes profits by playing short-term noise against long term intrinsic value. He buys at the low end of market gyrations (Which is presented on the lower left side of our graphic) and then holds for intrinsic value to be realized (Upper right side of the graph). This does not mean any investor can consistently “pick the bottom”. What it means is that a real value investor buys with a margin of safety relative to long term value, such that they are able to hold the position until their estimate of intrinsic value is realized (or new facts change the estimate of intrinsic value).
The short term trader is often “on the other side” of those investors and traders who mistakenly think they are one thing (such as “investors”) when in reality they are something else (price sensitive speculators). Here are examples of trading concepts that in part build upon this idea:
- Buying a dip after a low % of range close
- Today’s price change impacts tomorrow’s return
- Where the close occurs within today’s trading range impacts forward return
Delusion is part of human nature and as such is an understandable foible. Yet in the world of trading and investing, the extent to which the trader can forsake pleasant fiction (While maintaining healthy optimism) is to a large degree the extent to which he has the capacity to achieve superior performance.
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