Investors and traders should focus on the medium-long term instead of the short term. This is the point that many traders – particularly professional traders – always forget. Many traders will short the market and hope that the market falls another $1, even though they know that a $10 rally is just ahead. Doing so is extremely dangerous.
The short term is hard to predict. The medium-long term is easier to predict.
The stock market’s short term direction is much harder to predict than its long term direction, purely from a statistical perspective.
- Since 1950, the S&P 500 has gone up on 52.9% of days (today’s CLOSE vs yesterday’s CLOSE).
- Since 1950, the S&P has gone up 61.1% of the time on a month-over-month basis.
- Since 1950, the S&P has gone up 73.4% of the time on a year-over-year basis.
Let’s assume that you are bullish on the stock market. It’s clear that the longer your time frame, the more likely your outlook is to be correct.
The short term is often confusing. Rarely will you get a scenario in which the short term is EXTREMELY bullish or EXTREMELY bearish. Hence, you will get a lot of studies that suggest different things (i.e. some studies will suggest that the market goes up over the next few days/weeks, others will suggest that the market goes down over the next few days/weeks).
Aways jump to a higher time frame when the short term is confusing. The medium-long term. Think outside the box. Think about the bigger picture.
Risk:reward states that you should ignore the short term
I continue to emphasis the importance of risk:reward in trading. This is the point that most short term traders forget. Here’s an example scenario:
- The market is currently in a correction.
- There’s an 80% chance that the market will fall another $1. But there’s a 20% chance that the market’s bottom is right here and that it won’t fall another $1.
- You know that the market will rally $10 once the correction is over.
What should you do? Many traders would short the market because they want to catch every single one of the market’s tiny movements. Some traders would wait for the market to fall another $1 before buying.
Get my book!
Here’s the correct thing to do:
Traders and investors should buy right now. Yes, there’s a >80% chance that the market will fall another $1 in the short term. But if the medium and long term are bullish enough, the 20% case (the market’s bottom is in) might just happen! You’ll miss out on $10 of profit because you wanted to catch a $1 profit!
The short term is extremely alluring. But here’s the simple reality: nobody can catch all of the market’s short term movements. More money has probably been lost than made by trying to catch the market’s short term movements. This is partially why hedge funds as an industry underperform the S&P 500.
Hedge funds are run by full-time, professional investors and traders. Yet they can’t even beat a simple close-your-eyes buy and hold strategy. To quote The Donald…
Risk:reward states that you should follow the medium-long term if the medium-long term and short term outlooks conflict. Short term bullish/bearish factors can be easily discarded. Medium and long term bullish/bearish factors last longer.
That’s why the optimal strategy is to buy and hold during a bull market, avoid the “significant corrections”, and avoid the bear markets. Ignore the “small corrections”.
A single market player
The short term is extremely random, while the medium-long term has fundamentals that determine the market’s direction.
Every market has fundamentals.
- The stock market has the economy and corporate earnings.
- Forex has Money Flow
- Commodities has demand for raw materials (think China building infrastructure).
- Even cryptocurrencies have fundamentals. I think crypto’s “fundamentals” is money laundering (that’s what it’s been used for). Probably 5% of Bitcoin’s value comes from money laundering while 95% of it comes from speculation.
You can consistently predict the market’s medium-long term direction if you have a solid grasp of its fundamentals.
The short term is extremely random because a single big market player can easily impact the market for a few days/weeks.
- The market will go down this week if pension XYZ wants to sell.
- The market will go up next week if institutional investor ABC wants to buy.
There are so many big market players that it’s impossible to predict the aggregate day-to-day impact of their buying and selling. Their actions impact the market on a day-to-day and week-to-week basis. But no single market player is big enough to consistently impact the stock market over the medium-long run.
Even the Fed cannot single-handedly cause a bull market or bear market. People say “don’t fight the Fed”. But they forget that the stock market STILL crashed in 2008 despite the Fed’s easy money policy.
- The Fed can only make a stock market that’s already rising go up even faster.
- The Fed can only make a stock market that’s already falling go down even faster.
- The Fed alone cannot reverse a bull or bear market. That’s up to the fundamentals.
- The fundamentals determine the Federal Reserve’s policy, not the other way around.
Taxes vary by country to country. But in general, long term capital gains are taxed at a lower rate than short term capital gains. Hence, short term traders face the additional burden of higher taxes.
Transaction costs used to be a big concern. This isn’t a big deal anymore thanks to cheap online brokers.