My approach to investing is founded on buying businesses for the long-term, not trading stocks for the short-term. At times of market volatility (for example, the start of this year), this might seem an illogical way to look at a stocks. The common thought is that these price swings have to mean something. Commentators on CNBC offer a trade of the day five days a week. Other commentators discuss the emerging technical patterns that will dictate price. There is plenty of pressure on investors to trade often and try to catch the market, or a stock, at the perfect time. The key concept to remember, however, is that most of the time short-term price movement doesn’t mean anything. It’s not a rational response to macroeconomic events or microeconomic news. It is what statisticians call noise. Try to outsmart the market’s short-term reactions and the market will leave you behind.
The most common type of response to market irrationality is that of the chart readers (technical stock investing). The claim is that one can foretell stock movement by the look of its chart; look out for a stock’s support on the bottom and the peak on top. One chart might show a double top, while another one shows trouble ahead.
A recent article I read on Seeking Alpha tried to predict the price of Apple (AAPL) using charts. The claim was that if Apple declines just a few more dollars, below $505, it “will complete a false upside breakout pattern on the weekly chart — and then watch out below.” So, that must mean that Apple is weak, time to sell. But, the article went on: “if AAPL rises above $525 this week, its MACD will turn up, negating its bearish divergence.” So, this sort of chart logic states that if the price goes down, sell, and if it goes up, buy. That’s the opposite of the old buy low sell high approach to investing. The real problem here is that this chart ignores all fundamentals for Apple and its stock. The value of Apple’s stock price and Apple’s long-term earnings will drive the stock in the long-term.
A few years ago, it occurred to me that with technical stock picking enjoying such a large following, there must be a series of great investors who made their fortunes reading charts. I did some research and I found no successful technical long-term investors the equivalent of Warren Buffett, Peter Lynch, and Benjamin Graham. Some technical investors do rise to prominence and make fortunes, but they then lose those fortunes within a few years.
Another interesting form of short-term trading is high-frequency trading. These traders use supercomputers to execute nanosecond trades with strategies so complex only mathematicians can understand them. Over the long-term, these traders do successfully use their algorithms to make money by exploiting mini-trends in stock price movement. Some retail investors find this type of trading worrisome, because it can move stock prices significantly in the short-term. I am happy that these traders exist, however, because they create prices useful in finding long-term value; since high-frequency traders care little about the fundamental value of a company, they often create great dislocations in stock prices. One thing to remember, high-frequency traders have very little impact on the long-term price of a company. Long-term prices are set by the fundamental worth of the company.
Another way short-term investors seek to make profits is by becoming market makers. Big banks like Goldman Sachs, JPMorgan Chase, and Morgan Stanley (and even hedge funds that generate revenue from trading) are making markets. Their role in the market is to buy on the bid and sell on the ask, which is inherently profitable. As retail investors, we buy on the ask and sell on the bid. Again, this is a form of short-term trading that relies on a very small profit for each transaction, but with high volume. Such trades make little difference when we buy or sell (it may change our return on the stock by a fraction of a percent). These traders do offer us opportunities, however. For example, when its computer malfunctioned, Knight Capital lost $400 million in a few minutes. These sorts of glitches provide value opportunities for patient investors.
Trading in the market on a day-to-day basis is a losing battle for retail investors. Successful investors focus on long-term investments, take advantage of opportunities when irrational markets misprice them, and have the patience to let their investments mature.