It is popular wisdom that daily trading in the stock market is dangerous. Here’s some perspective on why it is quite incompatible with how our brains work.
Firstly, let us model a good stock in simple terms. Let us say that this stock costs Rs 1000, and has a 51% chance of going up by Rs 10, and a 49% chance of falling by Rs 10 every single day. On a daily basis, the stock is likely to fluctuate up and down in the following fashion
Day 0: 1000
Day 1: 990
Day 2: 1000
Day 3: 1010
Day 4: 1020
Day 5: 1010
and so on….
Further, within each day, the stock goes up and down on in intervals that are random.
Now let us see what happens if we purchase this stock and leave it alone for a year (without looking at the daily price). Assuming that the market is open for 250 days a year, if that stock is left alone, the expected value of that stock at the end of one year is:
1000 + 250 x 10 x (0.51 -0.49) = 1500 Rs
Even with a meager spread of 2% (51% – 49%), this stock would yield substantial returns (50%) at the end of a year – more than most good stocks. Funnily enough, the daily series that we see above converges to the same result if the stock is left alone for a year.
But here is the catch. Our brains are loss averse. We are hurt more by losses than by gains. We are, on average, twice as likely to be hurt by losses than by gains of equal amounts. In other words, a stock needs to gain Rs 20 to offset the pain we feel when it loses Rs 10.
When we look at the series of stock prices above and see the stock going below the reference price of Rs 1000 (which can often happen) or if we see the stock losing money on three subsequent days (there’s a ~12% chance of this happening), the daily trader is likely to intervene and make changes to the portfolio. With hourly and minutely tracking in our connected world, this problem only grows even stronger. Needless to say, our interventions to our portfolio resets the annual equation we have mentioned above, which works only if the stock is left undisturbed even during periods of down-time.
As paradoxical as that might seem, our behaviour makes it beneficial to invest in a bunch of stocks and forget about them for long periods than to respond to daily fluctuations in the market. This strategy pays off even without considering the additional investment of time and emotional stress that is involved in daily trading. In other words, the human psyche does not set us up for success with trading on a daily basis.
It is true that traders can steel their nerves against daily fluctuations in the market and respond to them without much emotion. But even for professionals, doing that is much harder than it sounds. As for casual investors in the stock market, it is far more beneficial to buy some stocks and stay away from market prices or the constant noise from business channels for extended periods.
Inspiration: Fooled by Randomness – Nassim Taleb