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What is a ‘long-term investor’?

There is a tendency to equate ‘long-term investing’ with buying an asset and holding it for many years. While a long-term investor might indeed do so, being a long-term investor has more to do with the combination of an investor’s circumstances and the perspective they adopt. If anything, it is better described as a state of mind than by observed behaviour.

There is no widely-accepted definition of long-term investing. Neither is there any theory on what determines an investment horizon. Nevertheless, it can be argued that investors with long horizons are marked by two key attributes. First, they have high discretion over when they trade, and at what price. Second, their approach to investing is focused on the long-term.

Wait for opportunities

Discretion over trading provides the latitude to invest for the long-run including the option to hold an asset indefinitely. There is no pressure to invest immediately, and investors can wait for opportunities. This first attribute is almost a necessary condition for long-term investing.

The importance of unfettered discretion over trading is best understood by contemplating what happens when it is absent. If an investor lacks confidence that they can maintain a position as long as needed to secure the payoff, their horizon will recede. This issue goes beyond just the possibility of having to liquidate to meet some short-term cash flow need, or to service a liability that is falling due. It entails aversion to short-term underperformance due to concern over adverse reactions from your end-investors, your trustee board, or your boss. It can relate to the impact of short-term losses on capital or solvency requirements. It also extends to pressures to invest along with the crowd into recently outperforming assets, no matter how over-cooked.

Flows incurred by investment funds are an important influence. Flows may not only force a fund manager to trade; but wariness over flows (and the related focus on short-term relative performance that it entices) can induce managers to adopt shorter horizons. Indeed, much of the investment industry is configured to provide investors with liquidity, rather than deliver security of funding to investment managers. This aspect manifests in the form of open-ended funds offering immediate redemption, and member investment choice in the case of superannuation funds. Liquidity is valuable but there is a trade-off. Redemption-at-call impacts on manager perceptions of their control over trading, and is one of the factors that encourages short-termism. By contrast, private investors who are their own masters often possess high discretion over trading. This gives them greater latitude to pursue a long-term approach, if they want.

‘Trading’ versus ‘investing’

The second attribute of long-term investors relates to how investment decisions are made. Merely having discretion over trading is not enough. An investor must also behave like a long-term investor. This boils down to investment approach, including the information used in evaluating investments.

The main concern of a long-term investor should be long-term outcomes. In many cases, this will entail considering the cash flows that an asset can generate over the long run, relative to the price that is paid for that cash flow stream. Another concern should be what happens to the free cash flows generated by the asset: if the cash is not returned to investors, will it be reinvested wisely? That is, long-term investors focus on the drivers of long-term value and long-term returns. In an equity market context, relevant information is that which sheds light on aspects such as earnings potential, sustainable competitive advantage, future investment opportunities, management alignment and competency, and so on. A long-term investor will pay attention to this type of information, and filter out the short-term noise.

By contrast, short-term investors are primarily concerned with the drivers of price. The very simple reason is that short-term returns are dictated by price fluctuations. Such investors would hence focus on aspects such as news flow, how the market may respond to earnings announcements, the actions of other investors, current market themes – anything that could result in a price reaction. The difference between short-term and long-term investors is closely related to the concept of ‘trading’ versus ‘investing’.

Thus long-term investors are best characterised as those who set their sights on the long-term, backed by considerable discretion over trading. Why not holding period? In essence, the aim of long-term investing is to achieve the best long-term outcome, not just to buy and hold for extended periods. The option to trade is valuable, and may be used to enhance long-term outcomes. This is foreseen in the academic literature, where researchers such as Robert Merton as well as John Campbell and Luis Viceira point out that portfolios should be adjusted if expected returns vary over time. The fact that an investor trades does not make them a short-term investor. What matters is how they make investment decisions.

To drive home this point, consider the following situation (with thanks to Jack Gray). Assume you buy an asset with cash flows that are expected to grow strongly over the next 20 years from a low base. The asset offers you a 20-year expected return of 15% pa. Over the next year, the asset price triples. The long-term expected return consequently falls to 6% pa; and there are other opportunities offering a much better return. As a long-term investor, what do you do? It is argued that it is totally consistent with long-term investing to sell and invest elsewhere. What makes for a long-term investor is the fact that the decision is made with a view to the long-term expected return; not because of some slavish adherence to a long holding period.

Geoff Warren is Research Director of the Centre for International Finance and Regulation (CIFR).

CIFR has recently collaborated with the Future Fund on a research project examining long-term investing from an institutional investor perspective. This is the first 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

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