The long-horizon advantage defined
An investment belief shared by many is that those investors able to take a long-term view have a competitive edge over others that don’t. In this article, I will explore and explain what I believe defines this competitive edge.
For any investment opportunity, there are probably two questions that are of most interest:
- Will this opportunity lead to a positive payoff in the future?
- Assuming yes, when will this positive payoff occur?
For me, the defining characteristic of any long-horizon investor is that the decision to invest is based on high conviction of a positive answer to the first question and has little to do with the answer to the second. This expands the opportunity set available to them.
Let me elaborate. Financial markets are not completely efficient (see the Thinking Ahead Institute paper Stronger Investment Theory for more). 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”, in value investing legend Benjamin Graham’s words; that is, prices and values will probably converge eventually. If this is indeed the case, an investment opportunity can be identified when price-value divergence is detected – a difficult but plausible task.
On the other hand, 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, leaving short-horizon investors at the mercy of whether markets move quickly enough to reflect their views. As John Keynes rightly pointed out, “The market can stay irrational longer than you can stay solvent.” Its activity can be challenging, if not dangerous (particularly with leverage).
As a result, the key competitive edge of long-horizon investors involves their skill and their mindset. The key skill is their ability to identify the price-value divergence and the relevant mindset is their willingness to wait patiently for the convergence to take place.
In other words, long-horizon investors can participate in opportunities with uncertain timing regarding their future 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.
Let me use provision of liquidity as an example. During stressed markets, as in the global financial crisis, risky assets become under-priced due to a large number of investors being forced to sell to meet redemptions, among other reasons. Long-horizon investors can exploit this opportunity and harvest a premium when values and prices do converge. In fact, Warren Buffett made a handsome $12 billion with just one banking stock he purchased back in 2011.
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 required. It is entirely possible that divergences will continue to grow larger in the short term. (For a more comprehensive review of all opportunities available to long-horizon investors, see Eight paths to long-term premia.)
Long-horizon does not mean buy-and-hold
So, if long-horizon investors have the mindset and skills to wait patiently for investment opportunities to play out, does it mean they are buy-and-hold investors? No.
In my opinion, the concept of a long-horizon investor emphasises the mindset and skills of the investor. It is the ability to be flexible, not an obligation to hold assets for a prolonged period of time. Long-horizon investing is by no means a rigid buy-and-hold approach. The length of the holding period is driven by the speed at which price and value converge; it’s not pre-determined.
Even with a long-term approach, an element of dynamism can be important, as conditions and circumstances change fundamentally 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 has yet to occur.
Patient and active – that defines long-horizon investors.