Back in the day when we liked a song we would buy things called albums or CDs. This, for an 80’s era teen, was a risk when disks were $9-$14, so we had to determine if we could live with the album to justify the cost. Fast forward to today it costs $0.99 for one song you know you already like, at least at the moment. However, with songs becoming more commoditized due to so many downloadable options, musical trends can change so quickly that your “cheap” purchase could be a waste of money.
This reminds us of the equity market today. With artificial intelligence and high frequency trading becoming such an important part of market volume (approximately 50-70%) and quote activity (perhaps as high as 90%+), it has had a notable downward impact on average holding periods and likely impacting market volatility, an extreme example being the “flash crash”. This makes me tell myself every day when I enter the office “chances are I am not trading with humans, but with algorithms and I have no idea how those algorithms are structured.”
Therefore, I tend to do far less short-term trades of individual securities than I once did because of investment horizon risk. Because of these algorithms, my belief is that my risk/reward tradeoff may be neutralized by a computer that can establish correlations and execute risk arbitrage strategies more often, more accurately, and much more quickly than I could ever imagine. This in my opinion adds an element of risk that was not there before. Namely the impact of algorithms impacting market moves more than I anticipate during my investment horizon.
But what about valuation, doesn’t it matter even in shorter-term trades? Yes I believe it does, but likely beyond the investment horizon of my trade. By definition a trade is a very short term holding. It is not an investment. By the time the market does adjust itself, the time horizon for my trade may have passed and I could be stuck with negative alpha longer than planned.
Therefore, like me buying a song that I enjoy for the moment but quickly becoming a thing that takes up bytes on my IPod, short term trading in my view is riskier than it once was due to computerized trading algorithms. That’s why I tend to gravitate to names that I can live with longer than a moment—like my Elvis Costello records.