An investment belief likely to be shared by many is that those investors who are able to take a long-term view have a competitive edge over others that are not. In this blog post, I am going to explore and explain what I believe this competitive edge is.
For any investment opportunities, there are probably two questions that are of most interest to investors: (1) will this investment opportunity lead to a positive payoff in the future? (2) assuming yes to question #1 then when in the future will this positive payoff occur? For me, the defining characteristic of any long-horizon investors is that the decision to invest is centred around having high conviction on a positive answer to the first question while having little to do with the second, significantly expanding the investment opportunity set available to them.
Let me elaborate. It starts with a belief that financial markets are not completely efficient (for more on this please see the Thinking Ahead Institute paper “Stronger Investment Theory”). In the short term, swings in investment sentiment can create large divergences between prices and fundamental values. In the long run, however, financial markets may act as a “weighing machine” (Benjamin Graham), that is prices and values are likely to converge eventually. If this is indeed the case, a positive-payoff investment opportunity can be identified when price-value divergence is detected – a not-very-easy but plausible task.
On the other hand, I would argue that the timing of the price-value convergence is extremely difficult to predict, if possible at all. Prices can over- or undershoot values for a sustained period of time, leaving short-horizon investors at the mercy of markets to move quickly enough to reflect their views. As Keynes rightly pointed out – “the market can stay irrational longer than you can stay solvent” – this activity can be very challenging, if not dangerous (particularly with leverage).
As a result, the key competitive edge of long-horizon investors is their ability (skillsets) to identify the price-value convergence opportunity and willingness (mindset) to patiently wait for the convergence to eventually take place, regardless of the required holding period (assuming the investment thesis remains intact).
In other words, long-horizon investors can participate in opportunities with uncertain timing regarding their future positive payoff as long as they have high conviction on the investment proposition itself.
In practice it results in long-horizon investors being able to embrace many more investment opportunities that can be challenging for short-horizon investors to explore.
Let me use provision of liquidity as an example. During stressed markets like the GFC, risky assets become under-priced due to a large number of investors being forced to sell their assets to meet redemptions (along with other reasons). Long-horizon investors can indeed exploit this opportunity and harvest a premium when values and prices do converge. In fact, one of them (Warren Buffett) made a handsome $12bn with just one single banking stock he purchased back in 2011.
Nonetheless, in my view, this type of opportunity is not suitable for investors who do not have that willingness and ability to wait for the opportunities to play out, regardless of the time horizon required. It is entirely possible that divergence continues to grow larger in the short term. For a more comprehensive review of all opportunities available to long-horizon investors, please refer to our recent “The search for a long-term premium” paper.
So if long-horizon investors have the mindset and skillsets to patiently wait for investment opportunities to play out, does it mean they are buy-and-hold investors?
No.
In my opinion, a long time horizon is an ex-ante concept that has its key emphasis on the mindset and skillsets of the investor. It is a flexibility rather than an obligation to hold assets for a prolonged period of time. It is not necessarily a function of time although it can take time for price and value to converge. Long-horizon investing is by no means a rigid buy-and-hold approach. The ex-post holding period is driven by the speed at which price and value converge instead of a pre-determined long duration.
Even with a long-term approach, an element of dynamism can be important as conditions and circumstances fundamentally change over time. Long-term risk / return premia and investor risk tolerances vary through time, leading to necessary real-time portfolio changes. This involves responding to new prices and investment conditions with changes to portfolios that retain the essential long-horizon framework but trade positions where price-value convergence has occurred to new situations where it is yet to occur.
Patient and active – that’s how I would define long-horizon investors.