Patience, a depreciating asset

This post contains my first thoughts on the role of patience within long-horizon investing, a concept which cropped up over a coffee with Dr Geoff Warren (Australian National University) this June. We are currently exploring whether a co-authored paper on the topic makes sense.

To understand why patience might be important for long-horizon investment consider the following thought experiment. An investment is available, today only, for $100 that will pay $163 in 10 years’ time (equivalent to 5% pa) – without any opportunity to sell before then. The mark-to-market value of the investment will rise by 5% each year so the full return profile is known in advance (and the volatility is 0%). The investor’s required return is 4% pa. How much does the investor allocate to this investment? And can we conclude whether the investor is a short-term or long-term investor? The answer to the second question can only be inferred from the answer to the first question. If the investor allocates 100%, then there is nothing else for them to do but walk away for 10 years and get on with other aspects of life. The less the investor allocates then, perhaps, the more short term their thinking. But we haven’t got to the patience thing yet.

Let’s change two of the terms of the experiment. First, the mark-to-market value of the investment will either rise by 5% or fall by 5% each year. Second the investor can now sell their holding at the end of any year. Skipping the central range of possible outcomes, consider the case of nine consecutive 5% annual falls in price (setting up a spectacular 160% return in year 10 to get us to the $163 end point). The thought experiment is now more complicated in that even a genuinely long-term investor may be subject to mark-to-market constraints and therefore not free to allocate 100%. But it should also be clear that patience has a role to play in that there is now a requirement to wait in order to harvest the 5% pa return.

However, simply waiting a number of years for a certain outcome is only one aspect of patience. Once we introduce uncertainty to the final outcome – this apparently attractive investment could instead be a value trap – we approach the heart of why patience is so important to long-horizon investing.

From these thoughts, we can advance the hypothesis that the key differentiating feature of long-horizon investors is their ability to be patient. In the terms of our thought experiment where bad early paths are possible (and precluding the breaching of any constraint), the point at which the investor sells out reveals their true time horizon.

An alternative way of expressing this is that an investor’s ‘longness’ is tested by, and only revealed by, adverse outcomes. When returns are favourable the concept of ‘longness’ carries very little meaning or importance.

Implicit within this is a belief we should call out: long-horizon investors should only expect to earn a return premium over short-horizon investors by surviving periods of adversity (making disciplined, value-adding decisions – even if ‘to do nothing’).

It follows that patience will be tested. And this leads to the idea that patience should be viewed as a depreciating asset. In fact, this would lead us to define the observed behaviour of ‘capitulation’ as the point at which patience ran out.

We can also borrow insight from the 2nd law of thermodynamics (‘in a closed system, entropy (decay) always increases’): if the investor is a ‘closed system’ (ie has an initial endowment of patience, which then decays) then there will always be a point of capitulation if the outcomes are adverse enough. This shows that long-horizon investors must make themselves into ‘open systems’ where the restocking / replenishment of patience through time is possible if not inevitable.

As billed, this post is just the first sketch of some thoughts that need considerable development. One of the key questions we will need to answer is ‘how do you replenish patience?’. Presumably the supply of patience must come from the principal (or the governing board representing them), which implies the answer will include supportive governance. But can the principal have inexhaustible patience, or do we need to identify how they replenish? Then there is the gap between individual patience and organisational patience. How do we create and maintain organisational patience in the face of changing individuals either on the governing board, or within the executive? There is a fair amount of work required here, but it seems that the insight is likely to be important.