Citywire - Myopia and Markets
08 April 2010
The City has been castigated for short-termism, but why and what are the consequences? In 1936 Keynes defined speculation as ‘the activity of forecasting the psychology of the market’ and theorised that ‘as the organisation of investment markets improves, the risk of the predominance of speculation increases’. If this is true, then behavioural finance should continue to gain prominence.
The investment decisions that we make are bounded by our time horizons. This seems eminently sensible - if there is a known or even probable future liability, either in the form of a cash flow or lump-sum cash requirement, it should be taken into account. In the absence of known liabilities the goal might be to achieve superior risk-adjusted returns over a period of time appropriate to the instruments and methodology being used. So far so good, but recent experience is contrary. Holding periods for US equity mutual funds contracted 80% from an average of sixteen years in the 1950s and 1960s to just over three years in 2003 before settling at around four years pre-crisis. At the same time, turnover within portfolios increased from 17% to 110% per annum, implying a holding period for equities of just eleven months. Most analytical tools used by investors are not intended to work on such short time horizons, suggesting that many investors are, as Keynes forecast, engaged in second-guessing the psychology of the market rather than applying conventional fundamental analysis.
One explanation for the compression of time horizons is increased information availability. Besides trade and risk disclosures and marking to market, investment managers and companies report and are assessed on a quarterly or even a monthly basis even though the tools they use are effective over very different time frames. It could be that greater frequency and volume of information provides a degree of comfort to investors, though it may be a false sense of security, engendering overconfidence and leading to over trading. It seems obvious that increased trading results in increased costs, which detract from long-term performance. As a further caveat, even if it were successful, short-term performance does not necessarily translate into long-term gains.
In the immediate aftermath of the global financial crisis, investors’ time horizons shortened dramatically as they sought the most liquid instruments, those they could be sure of exiting if the world did end up crashing down around their ears. Herding towards the exits was an understandable if less than rational way to behave and provided a contrarian opportunity for those willing and able to take a longer view, reaping an illiquidity premium. Of course, being seen to be doing something, especially if it is the same course as others are following is a low-risk short-term strategy in reputational terms. However, being distracted by the noise around markets rather than focusing on longer-term changes to the conduct of business could prove a costly course to follow.
Frances Hudson, Global Thematic Strategist, Standard Life Investments
This article was first published in issue 61 of CWM and on www.citywire.com on Thursday 27th May 2010.
