In 2006, CFA Institute teamed with the Business Roundtable Institute for Corporate Ethics to explore the issue of short-termism in our capital markets. The resulting paper, Breaking the Short-term Cycle, evolved out of a series of symposia held during 2005 and 2006 that addressed the issue of short-term thinking in the financial markets. The participants in these meetings included corporate leaders, asset managers, institutional investors, and analysts. The report encourages all market participants to refocus on long-term value and provides recommendations on earnings guidance, incentives and compensation, leadership, communications and transparency, and education.
In the years since, a number of organizations, including the Committee for Economic Development and the Aspen Institute in the United States and the Department for Business, Innovation and Skills in the United Kingdom, have weighed in on the issue of short-termism.
One approach to the issue we haven’t seen much of has been a more quantitative or academic approach to the issue (the kind with lots of Greek symbols embedded in lengthy formulas). Luckily, a new paper explores the short-termism issue from a more quantitative point of view, and even offers some potential solutions. The recently released paper, The Short Long, by Andrew Haldane and Richard Davies at the Bank of England, offers a rigorous quantitative look at the issue of short-termism in financial markets.
Don’t worry, there won’t be a test on the math — but we have looked at the formulas, and they appear to make perfect sense.
The paper examines the effects of short-termism on investment decision-making. The authors argue that short-term behavior is significant among investors in capital markets, and is a trend that is growing. The authors conclude: “This evidence — anecdotal, survey, quantitative — is broadly consistent with popular perceptions. Capital market myopia is real. It may be rising.”
The Bank of England paper discusses a number of quantitative tests to assess the significance and scale of short-termism in equity markets, drawing on a sample of over 600 firms in the U.K. and U.S. over the period from 1980-2009. The tests assess whether expected future cash flows paid by a company are discounted “excessively” in the determination of its share price today.
The authors argue that some projects with a positive net present value might be rejected because future cash flows are discounted too heavily, reducing investment and, ultimately, growth in the economy. Second, long-duration cash flows and projects are penalized by excess discounting. Haldane and Davies note that, under rational discounting, cash flows even 50 years ahead retain more than 1 percent of their face value. Under the market myopia characterized by short-termism, cash flows have lost more than 99 percent of their value within 25 years. No one is waiting around for long-term projects to pay off.
The authors label this as a market failure, but also raise a number of policy proposals to reduce the effects of short-termism, including greater transparency about long-term performance, improved governance, and better contract design and tax/subsidy measures. In tackling short-termism, they conclude that “it might be time to increase the level of policy ambition. Without intervention, the long could become shorter still.”
Here’s hoping that other academics tackle this issue and give us more definitive evidence on whether or not we are in fact too myopic for our own good.