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Modern financial markets are truly stunning in their scope and complexity. Every day, trillions of dollars changes hands as market participants conduct tens of billions of trades among tens of thousands of securities from literally every city in the world. But what is perhaps hardest to appreciate about the market is how much it is influenced by completely random events. One day, more people want to buy General Electric stock than want to sell, so the price goes up. It might have nothing to do with anything that happened at GE. Next week, the opposite might happen.

Over the long run, markets adjust to allocate capital according to the underlying fundamentals of the economy. But over the short run – days or weeks – prices can be pushed to and fro as money sloshes through the system unevenly. So when asset prices suddenly jump up or crash, they tend to revert back to normal quickly as traders restore equilibrium. In fact, if you look at which stocks have performed the worst over the last month, historically they go on to outperform last month’s best performers by 2.49% the next month, a phenomenon known as the short-term reversal effect.

Most long-term investors like financial advisors ignore these short term effects, and will rebalance according to their long-run strategy – whatever that is – regardless of what’s up or down today. And it would be foolish to try to trade only on such short-term movements; the taxes and transactions costs would probably eat away all your profits and then some. But by using short-term signals to help guide the exact timing of long-term investment decisions, we can potentially add significant value over more simplistic trading strategies.

We monitor the markets every day for liquidity and reversal opportunities and only rebalance our clients’ portfolios when trading activity is in our favor. If it’s not, we sit patiently, knowing that conditions may be more favorable in a week or two. Research suggests employing such a patient trading strategy may improve the performance of an equity portfolio by about half a percent a year. For us, every day is an opportunity to add value for our clients.

References

Last month’s worst performing stocks go on to outperform last month’s best performers significantly: “Evidence of Predictable Behavior of Security Returns” by Jegadeesh (1990)

Long-Term Investors can profitably incorporate short-term signals into their trading models: “To Trade or Not to Trade? Informed Trading with Short-Term Signals for Long-Term Investors” by Israelov and Katz (2010)