The benefits of long term investing were outlined in the previous Cuffelinks article in this series. Long term investors have capacity to access a broader range of investment strategies, in part due to an absence of pressure to deliver short term outcomes. And they can exploit opportunities arising from the actions or aversions of the short term investors who often dominate markets. It all sounds good in theory. This article discusses why it is not so easy to do.
The distant future is hard to predict
While any investment is based on expectations about the future, both the challenge of forming a view and the potential implications of getting it wrong are compounded over longer terms.
Predictions about the distant future can be limited and of low confidence. Errors might simply result from poor analysis or bad forecasting. More decisively, the fundamentals may transform in ways that are hard to anticipate. ‘Regime shifts’ can occur in the underlying profitability of an industry or company, the economic environment, or market conditions. Financial history is littered with instances where supposedly durable features have been turned on their head. In the 1980s, markets were driven by inflation fears; interest rates were 15%-20%; PE ratios above 10 times were considered too expensive; Japan was the leading economy; there was no internet; and Australian media, building materials and gold companies were all highly prized. Banks were considered uninspiring, low-returning investments. All of this has changed. The people in charge also matter for how investments perform, and they too will change. The foundations underpinning any long term investment can shift and you don’t want to be on the wrong side.
The cost of getting it wrong
Incorrect expectations can have particularly weighty consequences when investing for the long term. Feedback mechanisms are hazy when expectations relate to a future that will not arrive any time soon. Long term investors who invest on false premises stand at risk of underperforming for a considerable period before the error is fully recognised.
Even once an error becomes apparent, extraction from the position can prove problematic. Often an underperforming investment will continue trading at seemingly low prices at which selling may seem unjustified, even though the initial rationale for the position has disappeared, i.e. it can turn into a ‘value trap’. Behavioural forces may come into play. The notion that we are ‘investing for the long run’ might become an excuse to avoid taking action. (This is one side of the ‘disposition effect’.) Further, many long term investments entail commitment. For instance, it can be difficult to trade out of unlisted, illiquid or opaque assets. And if their fundamentals are under pressure, a large haircut may be required to secure an exit. Basically, long term investors who make fundamental errors face the risk of getting ‘locked-in’ to underperforming positions. In contrast, short term investors more typically invest in a manner that facilitates turning over their positions, including the utilisation of stop-losses. They are less likely to get entrapped.
Staying the course
If a long term opportunity is correctly identified, exploiting it still relies on the commitment and fortitude to sustain the position. Long term investments might initially generate losses that persist for an uncomfortable period. Various forces could act to undermine commitment in such circumstances. Individuals who suffer doubt may be more susceptible to behavioural influences, such as the inclination to herd with the crowd. Fund managers can be placed under organisational pressures to address underperforming positions. Their investors could redeem funds; investment board support could crumble; or colleagues with a differing view may advocate for reversing the position. The managers themselves could get blamed for the underperformance, and replaced. The decision of whether to hold or fold on a difficult position can be tortured, and markets have a habit of creating maximum pressure to reverse course at exactly the wrong time.
Alignment issues within investment organisations
Investment organisations delegate decisions to ‘agents’ who may not be fully aligned with a long term approach. Investment staff could be operating on shorter horizons than their organisations, or the strategies they are supposed to pursue, as they are managing their own incentives or careers. Remuneration arrangements that are truly long term are rare in the fund management industry, where regular bonuses are paid. Staff may be concerned about promotion prospects, or their own value in the job market.
Many organisations such as superannuation funds outsource to external investment managers, and securing alignment can be tricky. The horizons of external managers are often limited because short term performance determines both the success of the organisation via the link to funds under management. A long term approach is hard to sustain when those making decisions are following a different agenda.
Avoiding the pitfalls
Long term investing must meet the challenge of dealing with long term uncertainty. As any forecast will likely be wrong, the aim is to build robustness into decisions. Three approaches include:
- Invest with a ‘margin of safety’ between the price paid and estimated long term value
- Evaluate investments against a wider range of scenarios
- Continually test the long term foundations for a position and don’t just set and forget.
A further suggestion is to favour positions that arise from the actions of short term investors in the first place. Long term investing is likely to work because the long term is undervalued in the markets, and not because it is easy. When an opportunity can be traced back to the actions of short term investors – such as the presence of forced sellers or buyers, or reactions to transitory influences – then a long term investor might take comfort that they are on to something.
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 series of Cuffelinks articles aims to bring out 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