Sunday, March 11, 2007

Great Article: Short-term versus long-term investing

Posted by Teh Hooi Ling, writer of the Show Me The Money column on Singapore Business Times:,4574,226950,00.html?

Added some comments in blue.

Short-term versus long-term investing

YOU pride yourself as a long-term investor. But a stock that you bought two months ago has now doubled in value. You feel that the price has run up a bit too far, too fast.
Should you then sell the stock or continue to hold it? (Good issue isn't it?)

Or take the reverse. You recognise that we are in a secular bull market, with many of the world's economies poised for multi-year growth. The stock market recognises the big picture and is pricing equities at about their fair value to reflect the expected growth. In this near-perfect picture, assume somebody starts to have a panic attack and begins dumping his shares. Others then follow suit. The market is correcting sharply, and many are beginning to talk about the beginning of a bear. Do you then sell, or don't? (And again, this reflected on so many of us, recently. Sell or no?)

Those who have done their fair share of reading up on the art of investing will know that long-term investing beats short-term investing.

All those who are legendary in the stock market have a few common traits: their ability to block out the short-term noises, the confidence to stand out in the crowd, and patience.

Think Warren Buffett, John Neff, John Templeton, John Maynard Keynes.

Few short-term traders managed to amass the kind of wealth anywhere near these investment greats.

Buffett once famously said he wouldn't care if the stock market closed for a year or two. 'An active trading market is useful, since it periodically presents us with mouth-watering opportunities,' he said. What matters to Buffett is the underlying economic fate of the business he owns.

'Charlie and I let our marketable equities tell us by their operating results - not by their daily, or even yearly, price quotations - whether our investments are successful. The market may ignore business success for a while, but it eventually will confirm it,' he said.

And indeed, a study has shown that the relationship between earnings and share gets strong the longer the time-frame. With stocks held for three years, the correlation between earnings and share price ranged from 0.131 to 0.36. (A correlation of 0 means one set of numbers does not explain the other, while a correlation of 1 means both sets of numbers move in perfect lockstep.)

With stocks held for five years, the correlation ranged from 0.374 to 0.599. And for a ten-year holding period, the correlation increased to a range of 0.593 to 0.695.

When worry strikes

However, humans are predisposed to short-termism.

All of us try to be rational all the time, but emotion intervenes. An example is the recent sell-down of the market. You were sitting pretty on a profit of about 50 per cent last Monday. Then came the Tuesday sell-off, and your profit diminished to 40 per cent. The following day saw another 10 per cent of your profit wiped up. And Monday this week, a bigger 15 per cent was erased, and you were left with only 15 per cent of profit.

Now more people were getting worried. And numerous market experts were quoted in the papers as saying, 'Protect your profits'. So what do you do? You were afraid that you were missing some key indicators and that indeed the world's economy is slipping into a recession in the next few months, and you'd lose all you profits and even part of your capital. So, you acted to protect your profit. But the day after you sold, the market rebounded, and as of yesterday, you would have seen your profit rise back up to 35 per cent had you not sold to protect your profit.

Another reason which predisposes us to short-termism is the onslaught of information that we in this high-tech age receive every second, every minute.

A US professor of psychology, Paul Slovic, has done a study on the bookmakers who established the odds on horse races. The bookmakers were given five pieces of information and asked to set the odds on a horse race. The odds were then compared with actual results.

After that, they were given 10 pieces of information and asked to set the odds. Next, they were given 20 pieces of information, then 30, and then 40.

The more information they had, the more their confidence rose. But their accuracy did not improve. The same is true for economists and investments and all human beings.

Perhaps two things could happen. The more information we have, the more confident we become. And with that confidence, we tend to make more decisions, and those decisions become increasingly short-term and more likely to be wrong.

Alternatively, the more information we have, the more confused and indecisive we get. And we act in one way, change our mind, and reverse our position in double quick-time.

Jack Gray, a market strategist in Australia, once took a poll at a conference. He asked participants to vote on who was most responsible for the evident excessive short-termism. Apparently the media won, with 89 per cent shooting the blame at us! Others too were held responsible: regulators, fiduciaries, fund managers, asset consultants, trustees, etc.

Everyone in the investment chain was declared culpable to varying degrees.

'Everyone blames everyone else. Managers blame the demands of full disclosures and the frequent reports required by regulations. Managers also blame consultants who also demand monthly reports. Consultants say they ask for monthly reports because trustees demand them. Trustees blame the members of their fund for short-termism, who in turn, blame the media for emphasising short-term performance. The media claims it is merely reporting the news,' he wrote in his paper.

However, resisting the temptation to fiddle, to do something, is critical to being a successful long-term investor, but our evolutionary heritage acts against us, said Mr Gray.

'Survival decisions are triggered in the limbic system, a primitive part of the brain that provokes instinctive responses. That limbic system helped us survive in an unpredictable world of hunters and hunted. But behaviour that provided a survival advantage a quarter of a million years ago on the African veldt puts survival at risk in the jungles of Wall Street,' he said.

So what can make investors more long-term focused? Apparently as long ago as 1986, Warren Buffett has suggested a 100 per cent tax on short-term turnover. And recently a US academic Bogle, argued for an extra dividend for longer-term holders of a stock.

Mr Gray offers three steps. First, recognise cognitive, psychological and institutional barriers to long-termism. Second, filter out short-term signals that do not have longer term significance. He suggests that having a small number of like-minded investors can help in maintaining clarity and discipline. Finally, one should spend some time developing and writing down what one believes about investments and the market, and why? Is the market efficient, that is, does it fairly value stocks all the time? What is the evidence?

Investment beliefs should also include a long-term investment statement that articulates your beliefs about the relevance and benefits of long-termism and how these views will be reflected in decision making.

Now back to the two scenarios at the beginning of the article. Ideally, you'll want to sell in the first scenario in the hope of buying back at a lower price later. Chances are, when the price declines, you'll step back further in the hope of it stabilising before entering. And it's likely you'll end up getting back at a higher price.

As for the latter, many may succumb to the pressure and sell a good stock.

Such are the tricks emotion play on humans.