Avoiding Short-Termism in Investment Decision-Making

Jack Gray
Centre for Capital Market Dysfunctionality, UTS Rawson East P/L Brookvine P/L CFA Seminar April 2010

Agenda
• Excessive short-termism is a sin
• Where does short-termism develop? • All participants bear some guilt • Long-termism has some benefits • 5 steps to getting to and exploiting the longterm

2

One of Many

3

Short-Termism Can Be Costly

4

Costly Indeed
“ … a swelling interest in investment performance has created an increasingly short-term oriented and … more speculative market.” Warren Buffett

5

Costly Indeed
“ … a swelling interest in investment performance has created an increasingly short-term oriented and … more speculative market.” Warren Buffett (1969)

6

Long-Term Takes the Moral High-Ground

7

Long-Termism Can Be Costly

8

Costly Indeed
• Neither

a panacea for investment virtue

- VHF hedge funds - 25 vs 75 year-old • Nor a paragon of investment virtue - Disposition effect - DB policy mix

9

Excessive Short-Termism Is a Problem
• Distortion of opportunities: * Momentum  Private Gain, Public Cost * Correlation: Qrt, Mo, Wk, Dy, …,Sec, …

10

Short-Term Valuation
£bn Profits Dividends Sales Assets MCap

Vodafone

1.3

0.9

6.7

1.0

214

Food Retailers Real Estate Gas Distribution Alcoholic Beverages Chemicals Tobacco Water Construction & Building Materials Healthcare Engineering Vehicles Diversified Industrials Distributors Print, Paper & Packaging Household Goods Oil Exploration & Production

12.7

8.4

250.6

99.2

213

343 companies in 15 sectors for the price of Vodafone

 10
11

9

 37

 99
As at 31/03/00; Source: GMO

Correlated, Yet Huge Swings
EAFE ex Japan vs. S&P 500
1.2
EAFE ex Japan +71% Currency +21% S&P +58% Currency +10% S&P +96% Currency +76% EAFE ex Japan +76% Currency +50% S&P +80% Currency +25% EAFE ex Japan +53% Currency +34%

1.1
Cumulative Relative Wealth in U.S. $ Terms

1.0

0.9

0.8

0.7

0.6

Correlations:
0.5 May-73

0.67
75 76

0.22
78 80

0.55
81 83 85

0.44
86 88 90 91

0.61
93 95 96 98 00 01 03

0.86
05

12

Source: GMO, Standard & Poors.

As of 6/30/06

Excessive Short-Termism Is a Problem
• Distortion of opportunities: * Momentum  Private Gain, Public Cost * Correlation: Qtr, Mo, Wk, Dy, …, Sec, .. • Churning destroys wealth • Substantial value permanently destroyed & transferred in extremes

13

Ever Shorter Short-Termism

14

No Contest: Turnover vs Returns
942 US Equity Mutual Funds: 10 Years to Feb 2005

180% 160% 140% 120% 100% 80% 60% 40% 20% 0%
MER:

12.0% 11.5% 11.0% Turnover (LHS) Pre-tax Returns (RHS) 10.5% 10.0% 9.5% 9.0% 8.5% 1.0% 1.1% 1.3% 1.3%
Source: Bogle

Churn, Baby, Churn
‘Value’ Chain: Market
14% 12% 10%

Fund
77% of Market

Investor

US Equity Mutual Fund Annual Returns 1983–2003

48% of Market

Return

8% 6% 4% 2% 0% Market
16

Fund

Investor
Source: Bogle

We’re All Guilty
Scurrilous Survey

Player Media Government/Regulators Financial Planners Consultants Members Trustees/Fiduciaries Investment Managers Corporations/Analysts

Guilty of Short-Termism? 89% 81% 81% 68% 64% 53% 27% N/A
17

So Is Long-Termism Virtuous?
“... to make the purchase of an investment permanent might be a useful remedy for our contemporary evils. For this would force the investor to direct his mind to the long-term prospects and to those only.” “ … it is the long-term investor, he who most promotes the public interest, who will in practice come in for most criticism...” John Maynard Keynes (1936)
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Long-Term Advantages
• Slight predictability …. via mean reversion

19

Mean Reversion in Action
log scale
100

US Stock Values Are Mean Reverting.

Real value of $1 invested at start of period, with reinvested dividends.

If returns were random, over different horizons, they should lie in this range 90% of the time.
10

1

Because they are mean reverting they have stayed within this far narrower range
0

0

5

10

15

20

25

30

Number of Years You Stay in Stocks.
Smithers & Co. Ltd.

Long-Term Advantages
• Slight predictability …. via mean reversion • Lower Risk? - Matches intentions horizon - Depends; annualised volatility , but … • Lower turnover  lower (certain) costs • Minimal competition  limited arbitrage • Alternatives; Sustainability?
21

Return of the 2-Armed Economist
“…it is not wise to look too far ahead; our powers of prediction are slight, our command over results infinitesimal …” Yup, that guy Keynes again

22

“Powers of Prediction Are Slight”
14%

S&P 500 dividend yield
12% 10% 8% 6% 4% 2% 0% 1871 1881 1891 1901 1911 1921 1931 1941 1951 1961 1971 1981 1991 2001

10yr US Govt bond yield

Source:: Global Financial Data

End May 2009 23

We’re Not Just Homo Economicus
“An exclusive concern with the long-term may be prescriptively sterile, because the long-term is not where life is lived. Utility cannot be divorced from emotion … A theory of choice that completely ignores feelings such as the pain of losses and the regret of mistakes is not only descriptively unrealistic, it also leads to prescriptions that do not maximise the utility of outcomes as they are actually experienced…” Danny Kahneman
24

The Enemy Is Us

Source: CIAweb site

25

5 Steps to Long-Termism
1. Recognise/struggle against barriers: - Cognitive: Re-read the masters - Temperament/Affect: Training? - Institutional: Incentives matter

26

5 Steps to Long-Termism
1. Recognise/struggle against barriers: - Cognitive: Re-read the masters - Temperament/Affect: Training? - Institutional: Incentives matter 2. Use anchors of long-term value-added: - Slight predictability - Human psychology (individual & group) - Rhythms of history
27

5 Steps to Long-Termism
3. Be selectively sensitive to the short-term but avoid Gresham’s Law of Investing: “Comforting short-term, urgent drivel drives out discomforting, long-term important information”

28

Drivel, Drivel Everywhere Nor Any Time to Think…

29

5 Steps to Long-Termism
3. Be selectively sensitive to the short-term but avoid Gresham’s Law of Investing: “Comforting short-term, urgent drivel drives out discomforting, long-term important information” “All man’s miseries derive from being unable to sit quietly in a room alone.” Blaise Pascal, c.1630
30

Thoughtful Inertia

Don’t just do something … sit there.
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5 Steps to Long-Termism
4. Develop strategic partnerships with managers, consultants, funds - Kultur is Kritical - Mandate flexibility * 10-year mandates; Closed-end funds * Well-structured PBF * Question turnover and agency effects

32

5 Steps to Long-Termism
5. Develop and use Investment Beliefs including a Long-Term Investment Statement: - Charter of decision-making - Estimates of risk-tolerance (relative, absolute, liquidity, ..) - Tolerance for explicable underperformance - Exposure to long-duration alternatives - Emphasis on sustainability
33

So How Long is The Long-Term?
Depends on … • • • • • • Liabilities Assets Markets Risk(s) tolerance Temperament Career/business
34

So How Long is The Long-Term?
• Pragmatic Advice: Push clients a bit beyond their comfort horizon • When pushed for an answer try ….

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So How Long is The Long-Term?
• Pragmatic Advice: Push clients a bit beyond their comfort zone. • When pushed for an answer try …. Seven Years

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Avoiding Short-Termism (Fin)
• Excessive short-termism is a sin

• All participants bear some guilt • Long-termism has some benefits • Learn to exploit the long-term • Have courage and wisdom
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Disclosure
This presentation is intended to provide information of a general nature and does not take into account investors’ particular needs, objectives or circumstances. Before acting on this information, investors should consider its appropriateness having regard to their own situation. To the extent permitted by law, no liability is accepted for any loss or damage that results from reliance on this information. While due care has been taken in preparing the presentation, no warranty is given as to its accuracy or completeness.
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