Short-Term Thinking With Long-Term Capital

Information is a double-edged sword in the investment industry. Investors now have access to more opinions, analysis, real-time prices and research than ever before. It cannot be overstated how much this has changed the investment landscape when you compare it to how things once were in the pre-Internet stone age of insider tips, expensive research subscriptions, phone calls and a lack of useful historical market data.

One of the downsides to all of this information being available at our fingertips is that it’s made investors much more short-sighted in their approach. Case in point from a recent Chief Investment Officer article about endowment fund returns:

US endowments recorded the lowest returns for the 2015 fiscal year since 2012 and reached a hiatus in outsourcing, according to NACUBO and Commonfund.

The joint study of 812 colleges representing a total of $529 billion in assets revealed endowments returned an average of 2.4% net of fees, a sharp drop from 2014’s 15.5%.

“FY 2015’s lower average one-year return is a great concern,” said John Walda, NACUBO’s president and CEO. “Lower returns may make it even tougher for colleges and universities to adequately fund financial aid, research, and other programs that are very reliant on endowment earnings and are vital to institutions’ missions.”

NACUBO does a great job of aggregating endowment asset allocation and performance information every year in their annual report. But I get the sense that many of these funds have an unhealthy obsession with their performance in relation to their fellow endowments. These numbers are now headline news the minute they’re made public. It makes no sense to me.

There are a number of other reasons for the short-sightedness from many of these institutions. They’re all ultra-competitive. Envy runs deep between these institutions so they’re constantly checking the peer rankings to see where they stand in relation to their fellow investors. Ego also comes into play when dealing with such large amounts of money at stake and group decisions with investment committees and alumni always looking over their shoulder. Then there’s the fact that investment committees pay so much attention to benchmarks that the monitoring periods become shorter and shorter.

My friend Morgan Housel sent me the following story which illustrates this line of thinking perfectly:

BlackRock CEO Larry Fink once told a story about having dinner with the manager of one of the world’s largest sovereign wealth funds. The fund’s objectives, the manager said, were generational. “So how do you measure performance?” Fink asked.

“Quarterly,” said the manager.

If your organization or investment fund can’t deal with one poor year in the markets — and let’s be honest, it wasn’t even that bad of a year in 2015 when compared with 2008 — then you don’t really understand risk in the first place. One year performance numbers are extremely dangerous when they’re not put into context.

Endowments have the longest time horizons of any funds in the investment industry. They’re technically set up to last in perpetuity (translation: forever). They do have to meet short-term spending obligations, usually in the 3-5% range in terms of their fund size, but many of these funds are also bringing in large donations on an annual basis that help cut down on endowment spending rates.

Here’s what happens when you make short-term decisions with long-term capital:

  • You constantly change your strategy and chase past performance.
  • You ignore any semblance of a long-term plan.
  • You end up being reactive instead of pro-active with your decisions.
  • You incur higher fees from increased trading, due diligence and switching costs.
  • You lose sight of your actual goals and time horizon.
  • You end up with a portfolio that’s built to withstand the last war, not the next one.
  • You lose out on much of the long-term benefits that come from diversification, rebalancing and mean reversion.

One of the easiest solutions I see to this problem is to think about your portfolio in terms of your various time horizons and risks. That means keeping enough liquidity in cash equivalents and high quality bonds to survive periods of below average performance and bear markets. Then you structure the remainder of the portfolio to meet various intermediate and long-term goals, respectively. That way you’re creating a portfolio based on your personal needs and objectives without allowing what others are doing to impact your decisions.

This is simply a form of mental accounting, but it helps to understand where you can accept and benefit from volatility (long-term capital) and where you cannot (short-term spending needs). It’s simply a matter of matching up your various liabilities and time horizons with different assets and risks. That’s the entire point of diversification, risk management and asset allocation.

Institutional investors love to show that they beat their benchmark or some risk-adjusted return target or their peers in the industry over the most recent one year period. It’s not as sexy to brag about, but a true benchmark will always be that they are able to meet their short-term liquidity needs and have a high probability of meeting their long-term goals and mission as an organization.

Source:
Endowment Returns Drop, Outsourcing Steadies (CIO)

Further Reading:
Goals-Based Investing

Here’s what I’ve been reading lately:

 

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  • Amit Sinha

    Ben – articles such as this are always a healthy reminder for long-term investors when we tend to get caught up with the short-term noise. There are two relevant items I would like to share that may be of interest to your readers:

    1. A simple chart that I put together on outcome/horizon based investing that helps visualize the target you are really looking at http://www.focus262.com/blog/2015/10/outcomes-drive-investment-decisions/

    2. Jagdeep Baccher at UC has taken the correct but “novel” approach of not constantly comparing performance with peers – what Harvard returned last quarter is irrelevant if your objectives are different

    • Ben

      Thanks Amit. I love the title of that white paper you linked to — outcomes are the new alpha. Good stuff.

  • Loretta Hutchinson

    What a breath of fresh air and common sense…

  • Allan Donsig

    From page 97 of T.W. Korner’s The Pleasures of Counting:

    A large and rich Cambridge college, which has already survived for 500 years and has every intention of surviving another 500, recently interviewed four sets of investment advisors. Each group was asked what they considered `long-term’ to mean. Three said five years and the fourth said three days.

    The book was published in 1996.

  • Sunil Reddy

    I consider myself has a long-term investor. Recently with the sharp declines in the markets, I have seen few of my stocks dropping 20% in no time. I was about to change my strategy & was planning to change my strategy to make short term decisions with long term capital. After reading your post, I feel I need to stick to my initial plan/strategy. Thank You.