I previously posted initial thoughts on this subject. The paper has now been published and this post has appeared in top1000funds.com.
We believe there is a strong link between patience and successful long-term investing, for two reasons. First, patience differentiates between long-horizon and short-horizon investors. Second, patience must be seen as a depreciating asset. Left unmanaged, patience will erode and lose its value.
Our thesis comes from Patience: not merely a virtue, but an asset – a paper co-written with Geoff Warren of Australia National University and Liang Yin of the Thinking Ahead Institute – and has two main components:
- Patience has value, because it: (a) supports the ability to invest for the long term, and (b) allows the maintenance of (initially) losing positions.
- Patience running out is bad, because it: (a) can trigger a value-destructive sale (capitulation), and (b) sends the wrong signals, which can undermine capacity to exercise patience in future.
We consider an investment that has a high chance of delivering a very handsome return. The only problem is that we don’t know when. The return could materialise tomorrow, or years down the track. What type of investor would pursue such an investment? Clearly, they must have patience. They must not be too concerned with when the payoff might arrive, although they should worry if it will eventually occur. They must be able to stay the course if the payoff is delayed. Being able to pursue such investments opens a class of potentially rewarding opportunities that an impatient investor may overlook.
Our thesis suggests a straightforward question: how does an organisation build and sustain patience? The question becomes somewhat more complex when there are multiple levels of two-way relationships, and there is the need for patience to span those levels. Nevertheless we suggest that a simple, generalised model with four elements can be used to explore the question:
- Two levels – such as principal / agent, or governor / executive – but more generally a high-level party and a low-level party. We exclude the single-level case of the principal investing on their own behalf. The two-level idea applies variously: within asset owners (board and in-house executive); between asset owners and asset managers, and/or within asset managers (boss-employee).
- The stock of patience resides with, and is controlled by, the high-level party (eg principal).
- The low-level party (eg agent) operates under a mandate while the stock of patience remains positive. The manner in which this is done influences the principal’s stock of patience.
- There may, or may not, be a shared understanding of the presence of patience, let alone agreement over the role it plays. However, we assert that the best relationships and investment outcomes will involve mutual agreement over the need for patience.
It is important to note that patience alone does not lead to investment success. Patience is no substitute for skilled investment analysis but, assuming genuine investment skills are given, what difference would patience make?
An investor has, broadly, three options for allocating their capital:
- Risk-free assets – these give a 100% likelihood of a (very) low return.
- Price-to-price investing – this is Keynes’s beauty contest game. It entails predicting the movement of psychology of the market. What matters is the price bought at, and the price sold at.
- Price-to-value convergence – here there is a high likelihood of an attractive payoff, and skill relates to accurate assessment of the value. But there is also the possibility that price and value remain divergent. The divergence might even get larger before convergence occurs.
Clearly for the first option, patience makes no difference. The second option is a noisy, zero-sum game and so doesn’t seem a natural place for patience to make any difference. For price-to-value convergence, however, we argue that patience is everything.
If price diverges from value the investor has three options: (a) sell, concluding that their analysis of value was wrong, (b) do nothing, or (c) add to the position as the prospective return has increased. It is patience, an intangible asset, that allows an investor to pursue options (b) or (c).
We believe the benefits patience brings are an expanded opportunity set; protection against value-destructive short-horizon behaviours such as selling low; and reduced transaction costs as a consequence of lower portfolio turnover.
We assert that, in all but trivial cases, patience will be tested. This is why it should be viewed as a depreciating asset. Hence it is important to understand what causes patience to wear thin, and what can be done to build and maintain it. We recommend organisations build the stock of patience from the very start through: gaining organisation-wide buy-in; creating a long-horizon oriented investment process; hiring the right people; and building a long-horizon culture. The stock of patience then needs to be maintained by: working on retaining trust; offering the right incentives; framing performance in the context of long-term objectives; and having leadership from the top.
We do not argue that long-horizon investing is easy. Nor do we claim that it is the only way to generate strong investment performance. Or that it is appropriate for all. Nevertheless, long-horizon investing can be well worth the effort for organisations that manage on behalf of savers with long-horizon goals, and that are capable of positioning themselves to do so. For such organisations, we believe it is helpful to view the building, and maintainence, of a stock of patience as a, or the, key foundation.