I’ve always gravitated towards long-term trading strategies. That is mostly due to the fact that I have a day job and a side job, so I simply can’t trade a strategy that would have me glued to a screen all day.
Luckily for me, there is quite a bit of evidence that supports the idea that long-term trading is the best way to achieve long term trading success. There are also plenty of examples of people who have build fortunes trading mid-term and long-term strategies.
When I came across a recent article by Dan Banaszak from The Market Fade called Why Staying Invested for the Long Term Matters, I expected more of the same reassuring long-term propaganda that I usually read. To my surprise, Dan took a really interesting angle in his article and I thought it was worth commenting on.
Compound Returns vs Compound Risks
Dan started the article off just like I expected he would:
The concepts of risk and return in finance and investing are so fundamental, you’d think there would be mastery of these basic concepts for the preponderance of market participants.
But then he shifted the focus away from compound returns and onto compound risks:
while many professional investors certainly appreciate the power of compounded returns over the long-term, it never fails to surprise me how many of these same investors don’t quite grasp the concept of compounded risk over those same longer time horizons.
In order to illustrate his point, Dan put together a basic example that breaks down expected returns of investing in the stock market over the long-term. He explains that if the average expected annual return for a stock strategy is 10% and the standard deviation of that return is 16%, then the strategy can reasonably be expected to return somewhere between -6% and 26% in any given year.
He continues be explaining that compounding that average 10% return over a three year period produces an average three year return of 33.1%. Risk, however, is not calculated in the same manner. In order to calculate the risk over a three year period, you would multiply the 16% standard deviation by the square root of three. This results in an expected range between 5.4% and 60.8%, which is much better than many would expect it to be.
Dan is quick to point out that this is just a simple example and years outside of one standard deviation are far more common that we give them credit for. At the same time, his point is that there is tremendous power and surprising safety in sticking with a strategy for a long time. Stretching out the time frame to 10 or 20 years makes even a 5.4% return extremely significant.
Instead of focusing on the next trade, try thinking in terms of the next 1,000 trades. That helps put into perspective how insignificant the action of today might be relative to the action over the next 10 years.