After investing in mutual funds for several years, I began trying to earn an exceptionally high return of 30% in future years by trading profitable stocks in short periods of time. Could I outperform the stock market with short term trading?
Short-termism is the habit of selling securities in the stock market after brief periods of ownership less than one year. My short-termism is summarized in figure 1 for the past thirteen years. According to the gold and green bar graphs, more short term than long term sales were made during the first ten years. The gold dashed line shows a steady decline of 3-year moving averages for short term sales after the eighth year. By the thirteenth year, the average number of short term sales fell below the average number of long-term sales (green dashed line). The portfolio’s average number of year-end securities (blue dashed line) varied between 17 and 20 after the fifth year.
Figure 1 legend. The annual numbers of short-term sales (gold bars), long-term sales (green bars), and year-end holdings (blue bars) are represented by the height of the bars. Dashed lines represent those numbers as 3-year moving averages. Each moving average is an average of the previous 3 years.
I compared my portfolio to the stock market using the “percentage return” measurement shown below in figure 2. Heights of the bar graphs for the portfolio (blue) and stock market (black) changed according to the percentage change in market prices between the start and finish of the year. Goal lines for “30%” and “-30%” represent exceptional gains and losses. At the end of 2008 (“year 1”) the portfolio lost 60% of its starting value compared to the market’s 37% loss. During year 2, my successful trading in the resurgent stock market lifted the portfolio’s percentage return by 54%. But successful trading had nothing to do with the portfolio’s 123% return in year 3. Instead, I made a one-time transfer of additional stocks into the portfolio from another investment account. Thereafter, with the exception of year 11, the stock market outperformed the portfolio as indicated by higher percentage returns. Short term sales (gold bars) accounted for the portfolio returns of years 1, 2, and 5, but otherwise failed to account for the portfolio returns [nor did long term sales (green bars); unsold securities usually accounted for most of the percentage returns].
Figure 2 legend. “Percentage return” of the “portfolio” and “market” represents the change in total value for each entity at the beginning (value1) and end (value2) of one year [return = 100(value2 – value1)/value1]. “Percentage return” of sales represents the net profits of “short-term sales” and “long-term sales” earned during the year as percentages of total portfolio value at the end of the year. The investment goal of 30% return is represented by the upper black line.
Figure 3 (below) clearly shows that my portfolio failed to achieve the goals of earning a 30% CAGR and outperforming the stock market. The portfolio’s thirteen-year CAGR of 7.9% was 1.9 percentage points below the stock market’s 9.8% CAGR and 22.1 percentage points below the desired 30% CAGR. In terms of cash value, a $1,000 sample of baseline investment ultimately grew to $2,690 in the portfolio (blue line) compared to $3,370 in the stock market (black line). At the stated “30% target” growth rate (dashed line), every $1,000 invested at baseline would theoretically grow to $4,000 in merely 5 years. The portfolio’s final surge in the last two years came from reinvesting 80% of the total value into an index fund that tracks the stock market.
Figure 3 legend. “Multiple” is the ratio of year-end value to baseline value. Baselines of the “Portfolio” and “Market” occurred at the close of trading in 1979 (time 0). Year-end value of the “Market” was reported by the Standard and Poors 500 Total Return Index. Multiples below 1.0 are losses and above 1.0 are gains.
Short-termism wasn’t the only reason I failed to earn a 30% annual return, but I believe it is the main explanation; here’s why:
- Fluctuating prices in the market prevent accurate timing of returns. Technical analysis of stock prices doesn’t guarantee accurate timing of trades.
- The fundamental analysis of stocks for short term trading is costly in terms of time spent on research and subscription fees for research reports.
- Frequent stock purchases can be an overwhelming task without the aid of an effective screening program and computer-assisted analyses. A problem with screening programs is the slow turnover of attractive stocks over a period of months rather than weeks. I began to run out of new ideas after a few months.
- A portfolio with too few or too many stocks is unlikely to beat the market. Underperformance of one or more stocks among a few securities incurs the burden of recovering losses before earning high returns. Too many stocks likely dilute the returns.
- I lost the opportunity to earn higher returns by selling good stocks too soon. Behavior analysts offer the opinion that long term buy-and-hold strategies offer a better chance of earning annual returns than short term sales strategies.
- Investing in distressed companies at low prices incurs an extended period of time needed for the company to recover its financial health and desired growth of earnings.
- Cash is necessary to purchase new securities, but too much cash dilutes the profits from short-term trading [please see “cash penalty” in the Appendix].
Conclusion. Bad choices and hurried trading most likely explain my subpar performance. The worst choice was purchasing shares of LEH (the listing of Lehman Brothers Holdings Inc. in the New York Stock Exchange) in year 1 when respected analysts warned against investing in such a deeply indebted company [more explanation in the Appendix]. And, hurried trading is a risky business due to unpredictable pricings and unexpected market declines. It’s less risky to purchase undervalued stocks of good companies and wait for however long it takes to sell those stocks at overvalued prices. A collection of healthy stocks protects from the inevitable decline of some companies.
Appendix: My trading behavior
30% goal. A compounded monthly return of 2.25% should yield a 30% annual return, which produces a compound annual growth rate (“CAGR”) of 30% when repeated for a period of years.
- net monthly returns of 2.25%
- Every sale is promptly replaced by a security that continues earning a monthly return of 2.25%.
- Negligible ‘cash penalty’ [cash penalty: every dollar of uninvested cash doubles the required monthly return from the same amount of invested cash].
My strategy was to sell stocks above cost by analyzing price charts. Frequent trading produced mixed results during the first two years (figure 2). Several trades earned sizable short term profits, notably stocks listed as GOOG (19%) and SOHU (14%). Other trades earned disasterous short term losses, notably LEH (-27%), SOL (-26%), and NVDA (-35%). The 2008 Recession occurred during this time period and undoubtedly contributed to my 60% loss in year 1. Year 1 ended with a portfolio of 4 stocks and $15 (~0%) in cash. During year 2, successful trading in a resurgent stock market lifted the portfolio’s annual return by 54%. The year-end portfolio held 27% cash and 73% securities which were comprised of stocks and one real estate investment trust (REIT).
[case history #1, LEH: My worst investment occurred in 2008 when I ignored the signs of a troubled company named Lehman Brothers Holdings Inc. to purchase its stock at several levels of declining share prices. Instead of a profitable rebound, the declining stock was delisted from the market when the company filed for bankruptcy. I felt demoralized by the end of 2008]
[case history #2, GOOG & NVDA: Had I kept these stocks for thirteen years, my final returns-on-investment would be 283% (GOOG) and 3,415% (NVDA).]
In year 3, the one-time transfer of stocks from another account boosted my portfolio’s return by 123%. My intent was to acquire additional cash from short term sales in order to buy interesting securities such as exchange traded funds (ETFs). The ETFs offered a layer of protection against corporate bankruptcies and stock delistings. Short term trading of securities continued during years 3-5 with the inclusion of sector ETFs and leveraged ETFs. The portfolio held 19% cash, 34% stocks, and 47% ETFs at the end of year 5.
My revised goal in year 6 was to consistently outperform the market by combining market-matching returns using ETFs with above-market returns using stocks. I would do so with an 80% investment in ETFs and 20% investment in stocks. Promising stocks from foreign countries were added to the portfolio and leveraged ETFs were abandoned. The remaining ETFs were distributed among four different asset classes: 30% stocks, 30% REITs, 20% investment grade bonds, and 20% gold bullion. The occasionally rebalanced ETFs offered good protection at modest returns that underperformed the stock market.
In year 12, I sold the diversified group of ETFs to reinvest in a single broad-market ETF that mimicked the U.S. stock market. I no longer needed to rebalance the portfolio, with the added advantage of automatically reinvesting the fund’s dividends. The new ETF enabled the portfolio to match the stock market’s resurgence in years 12-13 (figures 2,3). The portfolio held 3% cash, 16% stocks, and 81% single-ETF at the end of year 13.
Copyright © 2021 Douglas R. Knight