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By Wealth Foundations

It’s human nature to focus on the short term

When you look at a collection of one year share market charts (e.g. of the US market), it’s difficult to find a common pattern or trend among the charts. Yet, when you view a long term chart of the same market it’s hard to ignore the upward trend. So, what time period should we focus on when making investment decisions?

It’s human nature to focus on the short term. Benartzi and Thaler [1.] did an assessment to determine the time horizon the average investor, with a typically myopic aversion to losses, would use. They based the assessment on the observed difference in returns between stocks and bonds and determined the time horizon over which investors would find the two forms of investment to be equally attractive.  They found it to be about a year. So, from a behavioural perspective, investors (on average) prefer to make decisions by considering what they think will happen over a one year time frame.

Market participants also tend to believe that short term market returns are more predictable than long term returns – mainly because the information and outcomes are closer in time. Yet, short term market movements are extremely difficult to accurately predict (and especially to do so consistently). More often than not, investors are susceptible to simply projecting a continuation of the most recent conditions.

The evidence suggests that we’re becoming increasingly short term with our decision making time horizon. Fifty years ago, the average holding period for an investment portfolio was seven years (meaning around one-seventh of the portfolio was traded each year). Today, the average holding period is less than a year (11 months).

This emphasis on short term movements in market prices leads to a tendency to overtrade, which has a detrimental effect on an investor’s long term portfolio performance.

The Costs of Over Trading

To demonstrate this, we compared the impact on returns of two different investor approaches. The first investor takes a long term view and has an average portfolio holding period of seven years (i.e. a low turnover approach). The second has short term focus with an average portfolio holding period of 12 months (i.e. a high turnover approach).

We assume that both investors hold portfolios that are exposed to the same level of risk and consequently experience the same return environment [2.], before costs and taxes (at 9.1% per annum). We assume each investor starts with a portfolio value of $500,000.

The chart below compares the movement of each portfolio, after taking into account the impact of costs and taxes, over a 30 year period.

The outperformance of the long term (low turnover) approach is quite considerable.  The (low turnover) investor ends up with over 15% more capital at the end of the period. The difference primarily reflects the drag of costs and taxes, factors that are often ignored in the short term but have a sizeable impact over time.

We assumed a fairly modest level of transaction costs at 0.5% (based on the traded amount). Each investor had the same tax rate throughout the period and both were eligible for the 50% capital gains tax discount. We also ensured that both portfolios were liquidated at the end of the 30 year period to ensure that all taxes were realised over the period. In other words, there were no unrealised (untaxed) gains in either portfolio at the end of year 30.

To put the cost of a short term focus into perspective, we calculate that the high turnover investor would need to earn an additional 0.73% per annum (before costs and taxes) to overcome the disadvantage of trading more frequently. That’s a pretty tall order, especially when you consider that this additional return has to be achieved without increasing the investment risk exposure.

The above assessment just focuses on one of the disadvantages of taking a short term focus (i.e. direct costs and taxes). There are others, including the relative return costs between hiring and firing investment managers.

A recent study by Goyal and Wahal [3.] found that on average the timing of decisions to hire and fire investment managers detracted from value. Hired managers were hired after superior performance but their post hiring performance proved to be average (i.e. there were no out performance benefits after the hire). And, fired managers were found to frequently provide out performance after they were fired, sometimes at statistically significant levels.

Another benefit of a longer term approach is that you’re more likely to rebalance your portfolio in a disciplined way. This means you’re more likely to increase your exposure to risky assets in cyclical downturns and decrease exposure in cyclical upturns. This behaviour offers you the opportunity to add incremental returns as a result of the short term volatility of the market.

It all adds up in favour of taking a long term perspective when making investment decisions.

The importance of taking a long-term view

Many investors like to talk long term and act short term. But, as seen above, a short term approach has significant hurdles to overcome to simply breakeven with a long term approach.

It helps to commit (ahead of time) to a set of procedures to follow in the event that you’re tempted to make a portfolio alteration based on a hunch or knee-jerk reaction to recent events. It also helps to avoid closely monitoring the movements in your portfolio value.

The benefits of a long term approach to investing may not be apparent in the short term. It takes patience and discipline before these (compounding) rewards become clear but they are significant and can make a meaningful difference to your quality of life.

Click on the links below to read other articles from this week’s newsletter

Is it time to buy mining stocks?

18 Share Tips – 15 April 2013

How The Aussie Sharemarket Rates Globally

The Boomer housing bust: coming to Australia?

Support And Resistance Basics

How Oil Exporters Reach Financial Collapse

Top 10 shorted stocks

Stocks on a roll: ASX rolling 52-week highs

Stock on the slide: ASX rolling 52-week lows

 

[1.] Benartzi, Shlomo, and Richard H. Thaler. “Myopic Loss Aversion and the Equity Premium Puzzle.” Quarterly Journal of Economics, February 1995, pp. 73-92.
[2.] We assume each portfolio earns annual income of 3.5% and achieves an annual growth rate of 6.0%. Income is taxed at 46.5% and capital gains are taxed at 23.25% (after applying the 50% discount).
[3.] Goyal, A and Wahal, S, 2008, “The selection and termination of investment management firms by plan sponsors”, Journal of Finance, Vol LXIII, No. 4, pp 1805-1847.

 

Wealth Foundations (ABN 95 965 896 114) is a corporate authorised representative of Wealth Leadership Services Pty Ltd (Corporate Authorised Representative No. 319641). Wealth Leadership Services Pty Limited (ABN 36 121 535 993) is a licensed Australian financial services firm (AFS Licence No. 317369).

The material contained in this article is for general purposes only and should not be used as a substitute for personal financial advice. This article does not take into account your specific objectives, financial situation or needs. No person should act or refrain from acting solely on the basis of this material. Before making a financial planning or investment decision, you should consider if it is appropriate for your circumstances. You should read and understand any relevant Product Disclosure Statements or any other associated documentation relevant to your individual situation.