Can Short-Term Investor Beat Long-Term Investors?

time horizon
  • Holding on to winning stocks means +7% return annually compared to active investors
  • Some (few) informed investors earn more at shorter intervals with private information and liquidity provision
  • Stocks that are heavily purchased are likely to continue an uptrend for up to 2 weeks
 

Holding on to winning stocks means +7% return annually compared to active investors

“Only buy something that you’d be perfectly happy to hold if the market shut down for 10 years.”

The truth is investors who trade frequently are more likely to face poor performance. Investors who hold on to “winning” stocks earn 7% more than investors who do not because of taxes and trading cost implications. Although a small majority of investors can actively game “earning releases” and trading volume to earn enough to offset tax and trading costs, the majority of investors do not. However, we can confidently say that longer time horizon results in better portfolio performance overall.  

From a population of 65,000 investors, 20% of the most active investors earned an annual return of 11.4%, while 20% of the least active traders earn a return of 18.5%. Typically, the least active investors are “buy and hold” investors, who only moving their investments for tax, liquidity, and rebalance reasons. The difference between the most active and least active traders marks a 7% difference per year, a significant amount for any investor. The reason for the difference is largely due to trading costs and tax implications. Investors who hold an investment for more than 1-year face capital gain tax rate from 0% to 20%, while investors who do not hold for more than 1-year can face capital gain tax rates between 10% to 37%.

Some (few) informed investors earn more at shorter intervals with private information and liquidity provision

Contrary to the evidence above, some investors earn significant returns over shorter horizons (1 day to 2 weeks). These investors were able to predict short-term run returns 10 days before an earnings announcement, earning them 1.5% more than investors who bought or sold these stocks two days before the announcement. However, the results are likely due to private information and liquidity provision, meaning the individuals here acted both as a market maker and participant:

“KST (researchers) argue that their results are largely consistent with individual investors acting as […] liquidity providers to institutions that require immediacy”

Simply, the investors profit from both trading and the gain from the “bid-ask” spread when borrowing their shares to other traders.

Stocks that are heavily purchased are likely to continue an uptrend for up to 2 weeks

Moreover, research also points to the use of order imbalance to predict the short-term price for up to 2 weeks. When order imbalance is measured weekly, stocks that are heavily brought, outperformed for 2 weeks before underperforming for the remainder of the year. In this system, the stock is determined to be a buy if the price is above the weekly quoted spread. And, the stock is determined to be a sell when the weekly current quoted price is greater than the current price. Afterward, the stock is likely to underperform. The researcher quote:

“In the short run, sentiment temporarily pushes prices above fundamental value, leading to predictable long-run return reversals.”

However, these results are still an ongoing debate around investor short-term success.

Studies in Taiwan have documented losses in the short-term from 1994 to 2002. Therefore, the result is still mixed. The reason for the success of retail U.S investors can be hypothesized to be simply institutional investors submitting orders as retail traders. Moreover, the Taiwan market present more accurate results since, 90% of trading activities can be directly traced to retail investors. Nevertheless, we can conclusively say that investing with a time horizon of 1 year + is still superior.

 

Source: The Behavior of Individual Investors (2013)

 

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