“Never think that God’s delays are God’s denials. Hold on; hold fast; hold out. Patience is genius.” – Comte de Buffon.
Interviewed by Steven Drobny in 2006 (“Inside the house of money”, John Wiley & Sons), Barclays Capital’s portfolio director John Porter made the following comments about his trading activities:
“What I am doing at Barclays nowadays is engaging in time horizon arbitrage. All investors these days are replicating the same very short-term style. Whether it is hedge funds, funds of funds, prop desks or real money, the good old days of a strategy session to discuss portfolio changes are over.
“Nobody can do that now. Everybody is held to parameters that don’t allow for any volatility in earnings. To me, that’s a good thing, as long as I don’t have to follow that formula. I believe that by executing a strategy that nobody else can, I will outperform. Does that make me any better ? Not necessarily, but it gives me an edge.”
In the same book, Falcon Management’s Jim Leitner makes an almost identical point. The capital markets are busily channelling billions of dollars towards hedge funds with monthly or quarterly redemption terms which forces the managers of those funds to manage their liquidity accordingly:
“If all investors allocate money to a one-month time frame, by definition there are going to be fewer opportunities there.. there’s just too much competition over short-term trading, which is a timing-driven business. With timing, sometimes you’re going to be right and sometimes you’re going to be wrong, but it’s not going to be consistent over time.. Meanwhile, the longer-term opportunities still exist because there hasn’t been that much money allocated with multi-year lockups.. That’s not happening yet and probably won’t because investors are way too nervous and shortsighted.”
Longer term investors with a wholly unnecessary requirement for liquidity (see also: sceptics of private equity funds) should be careful what they wish for. With a largely irrelevant penchant for rapid access to capital, allied with a bizarre aversion to even modest short-run mark to market losses, they run the risk of sacrificing thousands of basis points in longer term returns.
Portfolio manager Arne Alsin makes a very similar observation in the Financial Times (“When analytics, not time, is truly of the essence”). Alsin reduces successful stock market investing to two fundamental questions: “What does it cost ?” and “How much is it worth ?” The breathtakingly simple conclusion is that investors capable of answering these two questions to their own satisfaction – and with some degree of analytical precision - can stop there. Nothing more is required to be successful in equity investing. The problem, of course, is that investors invariably allow the extra variable of time to enter the equation. The problem is compounded by the inevitable pricing noise that arises from the interactions of multiple investors within a market.
In this respect, the long-term value investor who has some ability in cost / value analysis runs only one real risk: the risk of being early into the investment. On the basis that this investor is also attracted to higher-yielding, income-distributive situations which are likely to be out of favour (having already encountered previous selling pressure from his impatient rivals), even the risk of being too early is hardly likely to be fatal. Where carry contributes during the holding period, the likelihood of significant profit impairment is further reduced.
A number of investment commentators have written about the malign impact of timing pressure on portfolio performance. This pressure has been exacerbated by rapid improvements in global communications and transactional efficiency (read: the Internet), and it is doubtful whether our ‘cave brains’ are well suited to adapting to this new, quasi-instantaneous trading and feedback culture, even whilst increasing information transparency acts as a lure to our baser instincts to overtrade. This week provided a handy example. Within minutes of the release of buoyant Chinese economic data, European stock markets were tumbling– for at least the second time this year, spooked by unsubstantiated and largely wordless Asian fears. Perhaps the most instructive creation warning of the siren effect of timing, allied with redundant information flow, is Nassim Nicholas Taleb’s retired dentist, who is guaranteed to earn 15% per annum from his portfolio with 10% volatility. If this investor monitors his portfolio in real time, however, depending on the frequency with which he observes his holdings, he will encounter various degrees of happiness and distress. (The behavioural financiers tell us that the pain of loss of capital is approximately 2.5 times as severe as the pleasure created by gain.) The frequency of portfolio observation versus probability of pleasurable outcome chart for our dentist friend is shown below:
Timescale - frequency of portfolio monitoring: Probability of favourable outcome:
1 second 50.02%
1 minute 50.17%
1 hour 51.30%
1 day 54%
1 month 67%
1 quarter 77%
1 year 93%
(source: Fooled by Randomness by Nassim Nicholas Taleb, Texere Publishing.)
In other words, if Taleb’s dentist turns day trader and monitors his portfolio throughout the entire session, he will very quickly become emotionally exhausted. If he merely restricts the frequency of his portfolio observations, he will boost his chances of incurring a positive emotional outcome even though nothing has changed about the constitution of his portfolio. Conclusion: investors determined to watch the pot may end up scalding themselves.
In terms of profit potential, index-trackers are handing opportunities to generate alpha over to intelligent active investors in control of their emotions. Similarly, hot money investors with constraints over liquidity and a limited short-run tolerance for loss are handing alpha opportunities over to long-term investors with emotional discipline. Given the $2 trillion now widely accredited to hedge funds (and the likely associated leverage), ‘crowding out’ and hyper-competition within the short-run trading community (or at least those managers offering apparently attractive liquidity terms) may now represent a compelling opportunity for longer term real money investors with a reasonable sense of patience and emotional discipline.