Choosing the Duration of an Investment

Before the economic crisis hit the financial markets, i.e. when the indices were at their peak, with the S&P 500 close to 1,600 points, the Dow Jones around 14,000 and the Nasdaq, though far from its record of 5, 000 points, near the 3,000 level, buy and hold investors like Warren Buffett looked like financial geniuses. According to them, all you had to do was find a good value, take a position, and hold it for many years. But the current financial crisis has caused many to question this strategy. During this crisis, investors who bought and held stocks for a relatively long period of time lost the equivalent of a decade of accumulated returns. In addition, there have been periods in the past where the performance of the stock market remained anemic for close to a quarter of a century. The worst of the crisis is now thought to be over and a recovery is expected around year-end. However, there is no guarantee that this recovery will bring a return to prosperity. Many believe we will see positive growth for a number of years, but only on the order of 2%. So short-term, momentum strategies may once again become popular with investors.

Obviously, a momentum strategy involves a high number of trades. You buy when the market rises and sell short when it falls. In theory, this strategy should be profitable whether the market goes up or down. However, many strategies work well when backtesting but give very different results when put into practice. Research shows that frequenttrading strategies entail costs that are difficult to quantify when backtesting. These costs include commissions, market impact, timing, and opportunity cost.

No need to explain commission costs, since everyone understands the concept. By “market impact” we mean the effect a trade has on the spread between the bid and ask price. For highly liquid stocks, big volumes are necessary to move the spread, but everyone who has traded on direct-access platforms has had an experience where they try to sell 500 shares of a given stock when the market shows, for example, the bid at $25.50 and the ask at $25.60, with 100 shares on both the bid and the ask. You then have the choice of accepting the bid price of $25.50 or adding your 500 shares to the 100 being offered at $25.60. In both cases, the buyer often disappears and only shows up again when the stock drops. To know the impact on the market, the price must fall enough and there must be enough liquidity to execute the trade. The trade will thus have generated a lower return than expected. The dilemma is as follows: the longer the holding period, the less important this cost will be for the success of the trade, but, at the same time, the greater the risk that the price of the stock will move in the wrong direction. Consequently, timing is also a very important factor in the success of a trade. Generally, the poorer the timing, the longer the holding period must be for the trade to be successful and the greater the risk of loss in the short term.

Opportunity costs are tied to the fact that you cannot always execute your trades for the specified amount. If, for example, your strategy called for a position of 2,000 shares and you were only able to buy 1,500, the difference would represent the opportunity cost. This cost is practically nil, however, in a long-term strategy. Another opportunity cost is related to stop orders, which are essential in any short-term, momentum strategy. Being stopped out of a position that would have otherwise been profitable represents an opportunity cost. And it has never been proven that a momentum strategy can generate steady, high returns after taxes over a long period of time. Successful periods are followed by unsuccessful ones. So, which strategy should you opt for, buy and hold or momentum? It all depends on the timeframe you use to compare the two approaches. Over the past ten years, it’s quite possible that momentum traders have posted better returns, but probably not over the past two years.

In conclusion, the holding period for an investment must be in keeping with the investor’s strategy, whatever it may be. The investor’s objective may be achieved in a few minutes, or it may take many years, and the investment strategy must be established accordingly. In other words, a portfolio may be composed of different investments, each with a different objective.

The author

Marc Desnoyers

Marc Desnoyers

B.Sc., M.B.A., C.F.A