Lost in investment horizon

Kari Vatanen

12.11.2021, Blog

Institutional investors are often blamed for short-termism. Short-term performance pressures on investors can result in an excessive focus on short-term market movements at the expense of investors’ long-term interests. While long-term investing is more focused on investment strategy, fundamentals and long-term value creation, problems may arise in the structurally changing market environment. When is it time to update long-term investment beliefs if you get contradictory short-term evidence from the markets?

Investment risk management, as well as solvency regulation, is based on the measurement of short-term market risk. Investment assets are assumed to have sufficient market liquidity in efficient markets. The efficient market hypothesis ensures that changes in market prices are independent from the preceding ones and that current market prices can be used as fair values to the assets. Moreover, market risk is typically defined as a scalable deviation measure without tendency to mean-revert and the measure is usually estimated from the historical return distributions.

Institutional investors are used to managing their risk allocation by focusing on the probable maximum drawdowns on the portfolio level. Diversification benefits stemming from imperfect correlations between assets help to reduce the expected risk measures on the portfolio level in a static long-term world.

Investment risk management in the short term

The problems begin to cumulate when moving to dynamic short-term risk management in the zero interest-rate environment, where there are no diversifying asset classes in the case of market drawdowns.
Declining market prices decrease the value of the portfolio and that forces investors to reduce their risk allocation to maintain sufficient solvency level. If several investors are forced to sell risky assets at the same time, market liquidity deteriorates and the correlations between assets rise. Consequently, investors are required to reduce their risk allocation more and weakening liquidity causes even deeper drawdowns in the market.

Short-term market dynamics and the requirements for short-term risk management drive institutional investors to focus on the short-term market fluctuations and even strengthen them by their active risk allocation changes. Long-term risk management is both irrelevant and impossible for the institutional investors, who have short-term solvency requirements.

How to be a genuine long-term investor

There are, at least, two ways to avoid this kind of short-term investor behavior. First, they can allocate a part of their portfolio to illiquid assets which are not marked-to-market and adjust the portfolio risk slowly and smoothly over time. Second, they can just simply ignore the irrational market moves as a noise and trust that the asset prices will mean revert to their fundamental values over time. The latter requires a strong stomach for an investor, especially if there are regulatory requirements for solvency.

Genuine long-term investors set their faith on company fundamentals and on the continuity of long-term economic trends. Investment risk management can be based on qualitative reasoning of the underlying market fundamentals and rational beliefs of the future market trends. Asset price volatility is not a real risk if asset valuations are assumed to revert to the long-term trends over time. Instead, market volatility can create opportunities for liquidity providers to buy assets with lower valuation. Doing rationally the right thing is far more important than short-term market returns. Quite a similar approach seems to apply for many ESG-labeled investments, which focus on long-term impacts and investment returns.

Dispute over the base of knowledge

How do rationally-thinking investors know that they have made good investment decisions, if short-term market price fluctuations are assumed to be unnecessary noise without meaningful signals? The question resembles closely the philosophical dispute between rationalism and empiricism, which takes place within epistemology, the branch of philosophy devoted to studying nature, sources and limits of knowledge. The disagreement between rationalists and empiricists primarily concerns the extent to which we are dependent upon sense experience in our effort to gain knowledge.

Rationalists claim that our knowledge can be gained independently of sense experience. Intuition as a form of rational insight is associated with the philosopher Rene Descartes, who claimed that what we know, a priori, is certain, while what we believe, or even know, on the basis of sense experience is at least somewhat uncertain. The knowledge is gained by [a] deductive process in which the conclusions are derived from intuited premises through valid deductive arguments, ergo the conclusion must be true if the premises are true. For Descartes, this kind of knowledge was superior to any knowledge gained by sense experience.

In contrast, empiricists claim that sense experience is the ultimate source of all our concepts and knowledge. Sense experience is the only source of ideas and knowledge can be gained solely a posteriori, after the perceived facts. Since reason alone does not give us any knowledge, it certainly does not give us superior knowledge. Empiricism is common in the physical sciences, while rationalism is useful in logic and in some areas of mathematics.

How do we know about financial markets?

How do we know about financial markets and their behavior? Financial econometrics rely mostly on rational theory of utility-maximizing agents in efficient financial markets. It seeks to explain the behavior of markets by the rational theory which is calibrated on the basis of historical evidence. It is not very exceptional that markets deviate from theory, but that kind of irrationality can be explained by temporary behavioral noise while expecting markets to return to rational equilibrium over time.

Are we able to challenge the financial theory itself if empirical market evidence does not seem to support the theory anymore? The behavior of the markets might have changed e.g. due to massive and increasing monetary actions by central banks after the global financial crisis. Negative interest rates are a reality even if they are not rational according to financial theory. Lowly valued stocks have not outperformed highly valued ones in over a decade. The rise of ESG programs and regulation might change the market behavior even further in the future.

How do we know when is the right time to update our rational beliefs of financial markets when faced with evidence that contradicts with the theory? Academic researchers would probably say that the right time is when you have sufficient scientific evidence, but that is far too late for investors. The best we can do is to believe in our intuition and update our beliefs according to the evidence when our intuition tells us to do so. It is nothing but our rational insight that defines the judgement of our investment beliefs.

The article has been published in the Q3 edition of EQDerivatives Magazine in September 2021.

Kari Vatanen

  • Chief Investment Officer