After Short-Termism: The Uneasy Road to Long-Term Investing
Crises create challenges and spark debates that give us mirrors for introspection. Among the many important issues that arose from the 2008 financial crisis is the ever growing focus on short-termism in financial markets. To be clearer, short-termism, as defined during a CFA Institute roundtable, is the excessive focus on short-term results at the expense of longer term interests. Researchers in academia have shared compelling insights — both for and against short-termism. Industry leaders have been deliberating on the best approach. And with the jury still out, short-termism has been injected into the 2016 US presidental campaign as well.
The hope is that stakeholders follow this dialogue with concrete thought and action and, ultimately, with a better response than that generated for other slow-moving but grave short-term vs. long-term problems, climate change among them.
Structural Adjustments — Full Circle on Quarterly Reporting
The Dodd-Frank Act and Volcker rule are among the most important regulatory changes that address aspects of short-termism. The recent John Kay review on long-term decision making in UK equity markets is another notable milestone that has resulted in FTSE companies being exempted from quarterly reporting. Will other countries follow their lead? Many in Europe are against “quarterly capitalism,” but some in the United States aren’t convinced. It is interesting that quarterly reporting originally came into effect through the Securities Exchange Act 1934 as a partial remedy for the excessive speculation (i.e., short-termism) in the run up to the 1929 crash and the subsequent Great Depression.
Apart from corporate behavior related to quarterly reporting, there are many other aspects of the investment chain that demand review: increased turnover and shorter holding periods, voting structures and mechanisms that impose separate “investing” and “voting” decisions, problems with active management, closet indexing, and compensation structures, to name a few.
Furthermore, among the most important stakeholders, there is a misalignment of incentives across time and type. The ultimate investor beneficiary, for example, is interested in long-term performance in most cases. But her decision making is often driven by short-term measures, such as recent fund manager performance. As a result of this and other factors, most in the investment chain, including asset managers, have compensation structures based on short-term relative performance. Corporate executives, motivated by the need for better earnings (and stock prices), tend to make myopic investment decisions. The challenge therefore, as a leading academician notes, is to find ways to be a long-term investor in a world of short-term returns.
The Handicap
What are we trying to solve? Cause and effect in complex systems are often distant in time and space. Seemingly obvious solutions can actually worsen the situation. With numerous moving parts, all administered by humans, altering structures piecemeal to enable financial markets to think long term may not be enough. Corporate and institutional investors and the regulators who oversee them are all composed of people. Human beings with bounded rationality and cognitive limits tend toward “satisficing” rather than “maximising,” as the late Nobel laureate Herbert Simon would remind us. The strong bias we have for today at the expense of tomorrow is closely related to the conditioning that has forced us to depend on short-term wins. Instant gratification is a cognitive handicap that we would need to overcome. Unfortunately, we are biologically wired — we demand proof and are drawn to effects that are immediate and imminent.
Changes for the Long Term
At the risk of stating the obvious, the most vulnerable links in the investment chain are the beneficiaries, followed by the asset managers. So, from among the array of leverage points highlighted below, incentivizing these stakeholders to adopt certain behavioral changes is more likely to have a positive cascading impact on others in the industry. This is easier said than done and we need to lower our expectations. There is no magical formula. Virtues and good habits, adopting a “long-term greedy” attitude, can only develop from within and over time.
What remains possible, however, is to nurture an environment that allows our thinking to evolve.
Potential Leverage Points
- Companies: Visionary Directors
- Asset Managers: Incentive Structures
- Long-term Investors: Engage Better, Fiduciary Capitalism
- Well-Represented Investor Engagement: Highlighting the Needs of “Savers” to Companies
- Regulators: Incentives and Disincentives for the Long and Short Term
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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.
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Short-termism in bank credit was catapulted by the credit-risk (avoiding) weighted capital requirements. And no one said a word.
In 1988 with the Basel Accord, Basel I, the risk weight for the sovereign (government bureaucrats) was set at zero while the risk weight for the private sector (the citizens) was set at 100 percent.
And in 2004, with Basel II, the private sector was also split up into 20, 50, 100 and 150 percent risk weights.
The mother of all distortions on bank credit allocation ensued.
The last time I checked, in 2007, it was not even an issue for CFA. Is it a CFA issue now?
Many thanks for sharing views on the Basel Accords and the impacts that followed. It would be unfair to say that short termism was not considered as an issue at CFA Institute. As early as 2005, there was an active effort to deal with short termism (link 1). The emphasis on “Putting Investors First”, “Reasonable Basis”, “Diligence” and many other virtues of long termism have been enshrined in CFA Institute’s – Code of Ethics (link 2) for a number of years before the subprime crisis (if not decades).
http://www.cfapubs.org/doi/pdf/10.2469/ccb.v2006.n1.4194
http://www.cfapubs.org/doi/pdf/10.2469/ccb.v2014.n6.1
I was not referring to “short-termism” but to the credit risk weighted capital requirements for banks imposed by the Basel Committee. Nothing about that source of distortion was included in any CFA reading material, at least in 2007.
Thank you – it would be interesting to consider this as a separate piece of work perhaps.
I absolutely loved this – it is the first piece I’ve seen that acknowledges all the different moving parts and offers suggestions that could actually solve the problem rather than mask it temporarily.
Many thanks for sharing your thoughts and for the kind words.