Although some thought the financial crisis marked the end of long-term investing, it's still easy to find those who at least pay lip service to the virtues of long-term investing. "We invest for the long term" is one of the phrases we hear most often when meeting portfolio managers. Similar testaments to the long term are made by corporate executives and individual investors alike. The professed devotion can make it sound more like a moral imperative than an investment strategy.
Addicted to the Short Term
The reality is that few people actually act with the long term in mind. That's because performance is measured in increasingly shorter increments. For example, executives are notorious for focusing on meeting the City's quarterly earnings expectations. On the fund side, the average equity fund has annual turnover of nearly 100% (although the median is a more reasonable 67%), which suggests that every stock in a portfolio is sold over the course of a year. Most manager bonuses are based on three years or less of performance. Individual investors also struggle with staying committed, as my colleague Russ Kinnel discusses in this recent article.
The reason why few people stick with their investments over time is simple: It's really, really hard. Jeremy Siegel has argued that the riskiness of owning stocks shortens as one's holding period lengthens, as volatility smoothes out over time. But, as the financial crisis painfully demonstrated, there are lots of peaks and troughs along the way.
Academics such as Alfred Rappaport, Andrei Shleifer, and Robert Vishny have pointed out (see Rappaport's "The Economics of Short-Term Performance Obsession" and "Equilibrium Short Horizons of Investors and Firms" by Shleifer and Vishny) that making a long-term commitment to an investment actually means accepting far more uncertainty than someone with a shorter time horizon. That's because there's very little visibility in company earnings beyond a few quarters, much less five years or more.
So with most investors looking for immediate results, few corporate executives and fund managers are inclined to embrace the career risk that comes with making a long-term commitment to a project or company.
Delaying Gratification
Such behaviour creates opportunity for those willing to embrace uncertainty. As legendary investor Ben Graham pointed out, a long-term perspective can be one of an individual investor's greatest advantages, as they are not burdened by the need to focus on short-term performance. The theory is that the market rewards those who accept the greater uncertainty that comes with a long time horizon. Low trading costs and improved tax efficiency further sweeten the deal.
The key for fund investors wanting to exploit this edge is to find like-minded fund managers. But that's easier said than done.
Finding Good Partners
There are several traits common to the truly patient funds: low turnover, meaningful manager ownership, and long manager tenure. Manager ownership of the fund is particularly important, as it aligns their interests with shareholders'. It's even better if the manager is a principal at the firm, as many long-tenured managers are. Not surprisingly, funds with low turnover also tend to have long-tenured managers who have low career risk.
Importance of Buy Right
It's far easier for managers who are secure in their jobs to buy out-of-favour stocks that may take years to pay off. Such stocks tend to be less liquid and are potentially less efficiently priced than those that are traded frequently. These managers are willing to make a trade off, whereby they buy stocks that look cheap relative to a company's long-term prospects but lack near-term catalysts. Because they are planning on owning a given stock for a while, such managers often focus more initially on overall company quality. Making a long-term commitment--of any kind--has a way of focusing the mind.
Managers with short time horizons--and perhaps less-secure job prospects--are reluctant to forego visibility and prefer to stick with stocks where they see a catalyst to move the shares within six to 18 months. So, they need to be right often and within a small window of time, which courts its own execution risk.
Long-term investing isn't the only--or necessarily even the best--approach to managing money. But, its advantages extend beyond just low trading costs and taxes. If one does go this route, it's critical to find funds that have proved they can take advantage of the opportunities created by the short-term majority.
