My previous Cuffelinks article argued that long term investors are characterised by high discretion over their trading, coupled with a long term perspective. This follow-up sets out the advantages for such investors and the associated strategies they might pursue. Long term investing is neither easy nor a guarantee of success, but the main reason to expect it to succeed is because many markets are dominated by short term investors, implying the long term is often undervalued.
Three advantages held by long term investors draw on discretion over trading, which underwrites the capacity to maintain positions through difficult times, plus an approach to identifying opportunities that evaluates long term value or expected long term returns.
- Capacity to invest where the timing of the payoff is uncertain – Some investment opportunities have a high probability that a payoff will occur eventually yet the timing is uncertain. That is, they can remain primarily concerned with if, rather than when, they get a return. Capacity to be patient and far-sighted is useful when assets are discounted because of problems that should be eventually resolved. A long term investor is able to buy and wait. Meanwhile, short term investors may avoid seemingly ‘cheap’ assets due to aspects such as near-term business difficulties, evident selling pressure, or the absence of an immediate catalyst for price adjustment.
- Ability to exploit opportunities generated by short term investors – Short term investors may be required to trade or act in a short-sighted manner. This can result in assets becoming either mispriced, or offering unusually high (or low) returns. Long term investors may take the ‘other side of the trade’, precisely because they are not affected by the same concerns. For instance, many risk premiums arise because short term investors are averse to certain types of risks that long term investors are well-placed to bear.
- Latitude to invest in unlisted and/or illiquid assets – While it is true that a long horizon is required to invest in illiquid assets, this advantage is sometimes overstated, and viewed too simplistically. For instance, it can be dangerous to presume that an illiquidity premium exists just because an asset is illiquid. The real advantage is that a wider range of investments and strategies is available, including: opportunities arising from imperfections in illiquid markets; capacity to add economic value through direct control; and better diversification.
Overall, long term investing offers access to a broader opportunity set. Conceptually, long term investors can do anything that short term investors can do, plus more. Eight investment strategies where a long term investor might exploit their advantages are:
- Accessing risk premiums – Some risk premiums arise in part from concerns over potential for large, intermittent losses; while offering sizeable average returns for those who can hang in there. Included are market risk premium; volatility premium (accessed via volatility derivatives and options markets); illiquidity premium; and various insurance premiums, e.g. catastrophe bonds.
- Liquidity provision – During market crises, long term investors may buy from investors who are required to sell due to loss of funding or pressure to rein in their exposure. Recent examples include corporate bond and US housing markets during the GFC. Conversely, they might sell into liquidity-driven booms that push prices too high, and then sit on the sidelines unburdened by compulsion to remain invested. Trading against the market during these times requires both a long horizon and fortitude.
- Value investing – Value strategies often entail buying when prices are low because problems abound; and selling when prices are high because everything looks rosy. Hence value investors are typically acting against market opinion and momentum. Further, the timing of any payoff can be open-ended. There is a capacity to look through near-term pressures towards long term value and sustain a position.
- Exploiting pricing discrepancies across segmented markets – Pricing discrepancies can occur across markets that are related yet segmented due to frictions. Examples include discrepancies between unlisted and listed counterparts (e.g. unlisted versus listed infrastructure), or geographical disparities (e.g. property across countries). There is often uncertainty over the mechanism and timing of re-alignment.
- Long term thematic investing – Slow-moving but persistent trends accumulate over time and may be swamped by volatility over the short term. Examples might include the impact of long term macroeconomic trends, demographic changes, cultural shifts, technological developments and environmental change.
- Adding economic value through engagement and control – Long term investors might generate additional returns by applying their influence towards the creation of economic value, e.g. pursuing value-added or opportunistic property investments.
- Investing in complex assets – Complex assets can be attractively priced as a consequence of opaqueness, especially if uncertainties might take a long term to resolve. Investors with the resources to perform in-depth evaluations may benefit from waiting for the payoff.
- Dynamic strategies – Dynamic strategies of buying when expected returns are high and selling when they are low often amounts to a counter-cyclical approach that stands against the market. Dynamic strategies also incorporate holding ‘cash as an option’, thus keeping some powder dry.
In summary, most of the benefits of long term investing stem from a preparedness to take positions related to the actions or aversions of short term investors. Many commentators consider ‘short-termism’ as pervasive and a scourge. Another perspective is that short-termism provides a source of opportunity for those willing and able to adopt a long term approach.
Geoff Warren is Research Director at the Centre for International Finance and Regulation (CIFR). This article is for general information purposes and readers should seek independent advice about their personal circumstances.
CIFR recently collaborated with the Future Fund on a research project examining long term investing from an institutional investor perspective. This is the second in a series of Cuffelinks articles aiming to bring out some of the key messages for a broader audience. The (lengthy) full report, which comprises three papers, can be found at: http://www.cifr.edu.au/project/T003.aspx