In this monthly series, our experts examine a range of common investor biases and practical ways of overcoming them. Perhaps if we know the biases that we are prone to as investors, we can avoid them in the future.
BY NICK ARMET, 23 JANUARY 2013
'Human nature desires quick results, there is a peculiar zest in making money quickly, and remoter gains are discounted by the average man at a very high rate.' J.M. Keynes1
At the start of a new year, investors tend to ponder the prospects for the subsequent 12 months. It says something of how short term the focus in markets has become that this may be one of the relatively few occasions when many investors even think that far ahead. One of the understandable yet unhelpful consequences of the financial and sovereign crisis has been the short-term focus it has encouraged in many investors. Add in the use of quarterly investment performance to evaluate progress and the market’s relentless focus on quarterly earnings, and it easy to see how short termism has become a baked-in feature of stock markets. Such short termism, however, is at odds with building long-term portfolio wealth.
The evidence from major stock exchanges highlights that investors have become more short-term over time, if we consider the average holding period of stocks. In the US, the average holding period of a share on the NYSE was around seven years in 1940. The average holding period globally is now under three months (see Chart 1), and this is only partly explained by the entry of short-term, technically-driven investors.
Average holding periods of shares have fallen (now under three months globally)
Source: Goldman Sachs. Average holding period of all market participants by region. August 2013.
Short termism is unequivocally one of the most serious behavioural biases investors must overcome in their effort to produce market-beating investment returns. Our natural preference for short-term rewards – or instant gratification - over delayed gains has long been noted by psychologists as a feature of the human condition that extends to many aspects of our behaviour. Most noticeable in children, parents everywhere struggle to encourage their kids to see the value of delayed rewards in spite of the strong biological urge driving them to eat their treats immediately.
If investor behaviour is anything to go by however, this preference for short-term rewards never really leaves us in adulthood. Investing dials into deeply rooted cognitive biases and automatic responses in our brains thanks to the involvement of money, the presence of which has been shown to encourage emotional decision-making, particularly during times of stress.
Indeed, it turns out that investors are actually hard-wired for short-termism. In experiments, investors routinely value short-term gains more than they value delayed gains. The culprit here is dopamine, a feel-good chemical that our brains release when faced with a short-term reward. In fact, the possibility of imminent monetary reward has been shown to trigger dopamine release in much the same way as food, cigarettes or alcohol can.
Neuroscientists have shown that different parts of the brain are responsible for valuing short and long-term monetary payoffs.2 Behavioural studies have demonstrated most people would take £100 today over £200 in a year’s time, but would not take £100 in six years over £200 in seven. There is no rational reason for this inconsistency; the trade-offs are identical in monetary terms. From a neuroscience perspective, when the choice involves an immediate gain, the medial pre-frontal cortex is disproportionately used, a part of the brain associated with automatic, emotional thinking that is connected to the mid-brain dopamine system. When the choice involves two delayed rewards, a different calculating part of the brain (the parietal cortex) is used to make a more rational and patient choice. In order to take a long term view, we must recognise that our brains are wired against us – patience really is a virtue in investing.
The problem of short termism in stock markets runs deeper than just investors. It is part and parcel of how stock markets actually function due to the way in which future company earnings are valued by the investment industry. The issue here is that most sell-side analysts focus heavily on short-term earnings projections over the next one to three years. In fact, while the overall number of analysts covering large-cap global stocks continues to grow, the focus remains disproportionately on near-term earnings forecasts. Chart 2 shows the extent of analysts’ short-termism and the fact that relatively few forecasts exist beyond the third forecast year.3
Focus of sell-side analysts is on near-term earnings forecasts
Source: DataStream, Goldman Sachs. Number of I/B/E/S consensus EPS forecasts for US$1 billion firms. August 2013.
So, how should investors go about beating the market? One approach is simply to take a longer view than the market. Given the greater short-term focus of both investors and sell-side analysts discussed above, the equity market has become relatively effective at pricing near-term earnings expectations where there tends to be greater certainty. However, the market is less effective at evaluating longer-term earnings, showing a relative neglect for the longer-term value of companies exposed to strong structural growth. This represents an opportunity for investors and investment strategies which can sensibly identify structural growth winners.
Exposure to structural growth allows a company to generate a steady stream of cash which can be reinvested into a growing business. It is the ability of these companies to reinvest that cash into the strong growth opportunities they are finding in their markets – by increasing capital expenditure, which in turn, enables stronger sales and profits growth – that provides the compounding engine for sustained, long-term growth in their earnings.
And, this is where an understanding of longer-term drivers and trends such as demographics can be particularly useful in informing the investment process. Two companies which help to demonstrate the point are Essilor and Novo Nordisk. The former is the world leader in corrective lenses,4 such as varifocals, which means it benefits from two structural trends: ageing populations (needing more lenses); and the greater ability of emerging market populations to afford lenses. The latter company is a leader in diabetes treatment products. Diabetes affects around 371 million people worldwide, yet by 2030, this is expected to rise to 552 million.5 Over the last decade, the actual reported earnings of both companies have typically run ahead of “street” forecasts (in other words they have regularly beaten the market), which has allowed them to deliver attractive returns to their most loyal shareholders.
Short termism may be rife in equity markets, but the evidence suggests investors can use this to their advantage by taking a long term view and investing in those strategies which are designed to do likewise.
1Keynes, J.M. (1936).
2 McClure et al (2004) found that the parts of the brain associated with the dopamine system and implicated in impulsive behaviour are triggered when short term rewards are on offer, while delayed rewards were valued by a different part of the brain associated with calculation. For more, see McClure et al (2004) and Knutson and Peterson (2005).
3 This can be partly explained by availability bias (mentioned above) as there is a wealth of information available at any point to inform short-term forecasts.
4 Essilor, 2013 Annual Shareholder Presentation
5 International Diabetes Federation, 2012 Update
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