Short-term thinking is rampant --- June 5, 2015

Short-term thinking, called “short-termism,” is a destructive force, according to a May 2015 report by BCA Research. It’s defined as “the natural human tendency to make decisions in search of instant gratification.”

Both companies and investors opt for shorter and shorter holding periods for their stock market investments. Mutual fund managers must invest with short-term time horizons because of performance measurement pressures. CEOs of companies define short-term as less than two years. This situation, which is getting more pronounced, creates a great opportunity for individual investors.

As I wrote in my 1999 book, “Investment Traps and How to Avoid Them," the goal of investing is to buy low and sell high. I described how individual investors have a natural advantage over mutual fund managers and other professional investors. They can take a different path from the professionals to accomplish this, by concentrating their efforts in a longer time horizon and in “out-of-favour” sectors.

As the investment (and business) world gets more and more wrapped up in short-term time horizons of up to two years there are great opportunities created for those patient few who can look out three to four years. Attention spans are getting shorter and “instant gratification isn’t fast enough” for millennials brought up with video games and instant internet access.

The BCA report titled “The most destructive behavior and its economic consequences” claims that the short-term forces that grip the world are increasing, and that’s a bad thing.

Holding periods for investors in equities are reported at “21 months in the U.K. and a mere 7 months in the U.S., a fraction in comparison to the beginning of the 1980s.” Professional investors have to be short term thinkers. Managers of mutual funds, pension plans and hedge funds — who own about 70% of the market — have tremendous pressure to perform over a short time horizon.

Let’s look at how it works in the pension industry. Consultants advise pension plan administrators and review the performance of investment (fund) managers. These consultants can hardly keep from telling the pension plan boards that their manager is doing a great job and no change is necessary. Once in a while they have to recommend a change to justify their fees. Of course the main measurement tool is annual returns, even though annual returns are inadequate to judge a manager.

If a manager performs worse than his peers over a one or two year period he’s just asking to get the boot when the consultants write their recommendations. As a result, short-term performance is the only consideration for the fund manager when choosing a stock for the portfolio. If there’s a “hot” sector that’s doing very well in the market and all the other funds own an “overweight” position in that “hot” sector, every manager will hold a large position in that sector.

The BCA report mentions that “short-termism drives asset prices away from equilibrium.” The IMF’s Financial Stability Report in April 2015 noted “widespread evidence of herding in the mutual fund industry.” Go here for that report.

This means that fund managers will buy “hot” sectors and ignore “out-of-favour” sectors. They cannot afford to sit with “dead money”. There are few professionals who look at “out-of-favour” sectors so there’s a good chance of finding bargains there.

All of this “short-termism” among the fund managers creates a wonderful opportunity for others. The individual investor and portfolio managers who work with individuals can use this herding tendency to beat the market.

There is one difficulty and it can be a deal-breaker for some investors; this approach requires patience and conviction. There will be times when it seems to be a mistake to continue to hold stocks that aren’t doing much when the “hot” sector keeps pushing higher, and some investors cannot stand that.

But for those who can live with the uneasiness of being different from the crowd the rewards are large. Not only is there a better chance of beating the market but risks are lower when not chasing overpriced “hot” stocks that market participants own out of necessity. And if BCA Research is correct about the trend toward more “short-termism” the advantage will get better and better.

 

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