The Sneaky Danger of Style Drift
When trades become investments and investments become trades, returns are sure to suffer. Here's how to keep the two separate.
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One of the most common mistakes that investors make is that they do not have a clear plan in mind when they buy a stock and then react emotionally to price movement. A bad trade turns into a long-term investment, and a great long-term investment turns into a quick flip. Someone who intended to approach a stock like Warren Buffett turns into a meme trader, and a stuck day trader is now looking at a months-long relationship with a disappointing stock.
The justification for this behavior is that it is important to stay flexible after a stock is bought, because everyone knows that you have to cut losers quickly and let winners run. The problem was that there was never a clear plan to begin with, and now the entire thesis of the investment has shifted to a totally different time frame.
There are several behavioral biases that lead to a style shift. One of the foremost is what is known as loss aversion. Investors feel the sting of a loss to a much greater degree than they feel the pleasure of a gain. There is an asymmetric pattern of emotions that pushes investors to focus more on avoiding a loss than on trying to produce a gain. Unfortunately, this often manifests itself by not admitting that a trade has gone bad. Rather than just admit defeat, the investor hangs on to the stock and hopes it will eventually work out. The failed trade is now a long-term investment.
The flip side of loss aversion is that after a series of bad trades, investors are much more likely to take profits quickly on a good stock. There is a great desire for a victory, even if it is quite small. There are numerous stories about investors buying Apple AAPL at an early stage and selling after a move of a couple of dollars.
Loss aversion leads to the problem of letting losers run while selling winners too quickly, which is just the opposite of what you should be doing.
In a 2020 study by Barber and Odean, the authors found that retail investors who traded frequently underperformed the market by 6% annually, while buy-and-hold investors nearly matched it. The likelihood is that this happens because those frequent short-term trades are due to style drift and emotional decisions. When a trader reacts emotionally to a longer-term trade that has gone wrong, their decision-making is likely to be suboptimal.
So, how do you deal with the issue of style drift?
One solution is to maintain two different brokerage accounts. One account should be dedicated to longer-term investments, and one account should be dedicated to aggressive short-term trading. The primary benefit of this is that your intentions are very clear since you are forced to pick one account over the other when you make a buy. It also has the benefit of clearly allocating capital to those different levels of risk tolerance.
I maintain a small, aggressive trading account, which may be totally allocated to just one or two stocks that I’m actively trading. I may also hold the same stock in a longer-term account, but separating them into two different accounts makes it much easier to stay focused on the right time frames.
I believe that one of the best things that investors can do is to trade the same stock in multiple time frames. Hold a core position for the long term, but also have a plan for trading the same stock in much shorter periods. This allows you to modify your risk as market and technical conditions change. It is also much easier to hold on to longer-term investments if you change the position size while maintaining a core holding.
Style drift is a sneaky problem. Most investors don’t really recognize when it is happening, but when you have greater clarity about time frames, it allows you to understand how your emotions may lead you astray.
At the time of publication, DePorre had no position in any security mentioned.
