Finance

Message from the hunter-gatherer

Long-term thinking might not be humanity’s strongest trait. But while investments for the long-run are often praised, they are not a cure-all.
A man dressed as a neanderthal/ Credits: Reuters
The future is coming closer. Since the early 1990s, the average holding period for investments at major stock exchanges in New York, London and Frankfurt has dropped to less than a year, as figures from the Organisation for Economic Co-operation and Development (OECD) show.

The decrease was particularly noticeable at the Tokyo exchange and calls for a long-term approach in finance have since become louder, particularly in the wake of the 2008 crisis.

The OECD laments an increasingly short supply of long-term capital since the 2008 financial crisis and, in 2011, initiated a project to develop research and promote policy options to encourage institutional investors to invest in the longer-term.

The US Financial Crisis Inquiry Commission made a similar observation in its concluding report in 2011 where it identified banks’ overreliance on short-term debt as one of the main reasons for the 2008 breakdown.

"There is short- term thinking, not just in the financial world, but more broadly in our political system and our fiscal policies as well,” the former chairwoman of the Federal Deposit Insurance Corporation (FDIC), Sheila Bair, told the audience at the Economist’s Buttonwood Gathering. “It is a serious and growing problem in both business and government,” Bair stated earlier that year when leaving the FDIC where she had endorsed a policy of longer liability durations on financial institutions’ balance sheets.

Although often considered controversial, Bair finds herself in good company. While acknowledging the benefits of short-term investments, Joachim Faber, former CEO of Allianz Global Investors, criticizes the fact that “many investors are only interested in quick gains, which can create unacceptable volatility and inhibit sustainable developments.”

Andreas Utermann, Global Chief Investment Officer with Allianz Global Investors, calls for greater differentiation between trading and investing. “Their time horizons tend to differ considerably and the increase in technical trading, with very high churn rates, can skew the picture of the average holding period.” While prepared to take a long-term view on particular investments based on fundamental research, Utermann points out that this is always set against the moving target of alternatives.
A greater focus on long-term goals may not only help to reduce volatility, it may also reduce investment risk. “Sustainability criteria such as environmental, social and corporate governance (ESG) factors are too important to be ignored when making investment decisions today,” a study by Allianz Global Investors and risklab finds. By definition, these factors foster a long-term perspective.

“These so-called soft factors may create unpleasant tail risk and a severe impact on investment results across asset classes,” says Steffen Hörter, lead author of Responsible Investing Reloaded:. Sustainability Criteria Matter. “Portfolios should be analyzed for their exposure to ESG risks, for example an investment’s implicit carbon footprint,” Hörter concludes.

The study shows that the tail risk of an ESG optimized emerging market equity strategy could be reduced from -64.5 percent per year to -38.8 percent per year by optimizing the exposure to ESG factors. Similar effects are found with corporate bonds, albeit on a smaller scale.

Yet, short-term thinking might be too deeply ingrained in our biological hardwiring for a few thousand years of evolution, much less the handful of years since the financial crisis, to overcome.

Sheila Bair points to the findings of neurofinance as one explanation. “Which part of the brain becomes active when research subjects are presented with real-life decisions involving risk and reward? The more primitive system, which understands greed and fear, but is less focused on long-term consequences.”

The reasons for such behavior can be seen in neuronal activity deep inside our brain. Professors Camelia M. Kuhnen (Northwestern University) and Brian Knutson (Stanford University) have observed that areas of the brain that process information about risk, rewards and punishments also generate emotional states.

This might be an evolutionary relic from humanity’s times as hunter-gatherers, when risk and reward translated into acquiring food at the risk of death and an impulsive physical reaction could win the reward or even save the hunter’s life. Today, risk and reward are not so much physical, as pure intellectual challenges for most of us.
Nevertheless, emotions still influence financial decisions. “We find that positive emotional states, such as excitement, induce people to take risk and be confident in their ability to evaluate investment options,” says Kuhnen.

Anxiety, on the other hand, leads people to make more careful investment decisions, Kuhnen and Knutson report. In other words, when we are happy about recent, maybe even unexpected returns, we are more willing to take greater risk with our next investment.

Offering free food and drink therefore makes perfect sense for, say, a casino owner. The easy reward generates an excitement in which we are willing to take greater risks at the gambling table and ignore the inevitable long-term loss.

Not only that, we also learn selectively. “People do not fully incorporate news about investment options that seem to be at odds with their prior actions,” Kuhnen and Knutson write. To maintain a positive mood, we ignore new facts that contradict past beliefs.

But long-term is not the panacea it is sometimes made out to be. Conventional wisdom has it that long-term stock investing involves less risk than for the short-term. “That is false. Stocks are just as risky in the long run as they are in the short run,” says Zvi Bodie, Barron Professor of Management at the Boston University School of Management.

“In the context of retirement investing, the safest asset is bonds that have no risk of default and are protected against inflation. In the US, that asset class is Treasury Inflation Protected Securities, TIPS.” Investors better start with determining their personal risk preference before trusting time to mitigate all risk, Bodie advises – if you can convince yourself of to thinking about retirement that far ahead.


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