In one of my previous articles, we looked at Seth Klarman (Trades, Portfolio)’s thoughts on why it is that institutional investors lose money. After all, aren’t they supposed to be much smarter and better-resourced than ordinary retail investors?
There are many answers to this question, but the main one that Klarman identifies is that many institutional investors simply don’t have enough time to do proper due diligence, as they are forced to split their time between actually managing capital and courting new investors (as well as placating existing ones).
In a similar vein, I want to discuss another problem that financial professionals face: the difficulty of adopting a long term perspective.
Like dogs chasing their own tails
Thinking in the long term is of paramount importance for any value investor. It’s impossible to know exactly when an underpriced security will revert to fair value, only that it will do so at some point. As Benjamin Graham once put it, “In the short run, the market is a voting machine, but in the long run the market is a weighing machine.” For this reason, patience is essential.
Nonetheless, investors often find themselves working with relatively short time horizons, espectially institutional investors. Why is this? A major contributing factor to this bias is that fund managers are often themselves judged on fairly narrow time frames. If you are an analyst or a portfolio manager going into bonus season, or are someone who is up for promotion in the next few months, it's not in your financial interest to find investments that will pay off five years from now. You need returns next week, or next month at the latest. In his book, "Margin of Safety," Klarman describes this state of affairs thus:
“Like dogs chasing their own tails, most institutional investors have become locked into a short-term, relative-performance derby. Fund managers at one institution have suffered the distraction of hourly performance calculations; numerous managers are provided daily comparisons of their results with those of managers at other firms.”
Ostensibly, frequent comparisons like these should act to fuel the fire within capital allocators. There is a reason why the trope of the extremely competitive financial professional exists, after all. But in practice, all this does is push bad behaviour to further extremes.
Who is really to blame?
It can be gratifying for retail investors to poke fun at the seemingly irrational short-termism of institutional investors, but I think doing so obscures the fact that these professionals are not acting irrational with respect to their own self-interest. In other words, it’s not that they are dumb, it’s that they are often structurally incentivised to act in ways that are contrary to the long-term interests of their clients.
I think that viewing irrational market behaviour through the lens of institutional incentive structures is a more useful tool than assuming that the people making irrational decisions are stupid. Assuming that you know more about the market than the people on the other side of your trades is a sure-fire way to get cocky. But if you have a way of understanding why smart, well-educated people might have a selfish reason to sometimes act irrationally, then you will have a much better framework for decision making.
Disclosure: The author owns no stocks mentioned.
Read more here:
- Howard Marks; The Federal Reserve Shouldn't Encourage Bad Behavior
- Seth Klarman: What Junk Bonds Can Tell Us About Value Investing
- A Brief History of Junk Bonds
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