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Expanding Your (Time) Horizons
A recent study by Merrill Lynch argued that roughly 50% of hedge funds have
a time horizon of one-month or less. Expand the time frame a bit to one quarter
or less, and you encompass 90% of all hedge funds. Yet, in that short time
span, fundamentals in the economy don’t change that much! So hedge
funds (and other short term traders) are basically trading on the “noise” in
the markets.
Perhaps not surprisingly then, the study also found that such short-term
trading turned out to be a roughly 50/50 proposition — whether looking
at any given day, or over a period of 10 years, short-term trading success
is likely to be due largely to luck and the shorter the time period chosen,
the greater the chance of a loss. Perhaps this is why legendary value investor,
Jeremy Grantham recently suggested that as many as half of today’s
hedge funds will be forced out of business over the next few years — they
are the “unlucky” 50%!
Merrill concluded that individual investors actually have an advantage over
institutions because individuals tend to have longer time horizons. Their
advice was to ignore the noise and stay the course.
Undoubtedly, many individual investors do have longer time horizons than
institutions. Because individual investors are often investing for long time
periods (e.g., building retirement assets over decades), and don’t
have the institutional pressures of competing for business based on quarterly
investment performance figures, they should have longer time horizons.
Do Individual Investors Really Have Longer Time Horizons?
However, that supposed long-term time horizon can be affected by the frequency
with which investors check the performance of their investments! Now, there
are probably some investors who are extremely disciplined and can dispassionately
examine their investment returns frequently. But I would argue that the
more common reason most investors look at performance over short time frames
is because short-term market volatility is “making” them look,
causing them to wonder if they should be making a change. If they don’t
like what they see (i.e., their short-term investment performance) some
will make changes to their portfolios. In short, the more often someone
checks their performance, the shorter their likely “real” time
horizon becomes.
Why Time Horizons Matter
We have a question on time horizons in our client Confidential Investor Profile,
and the way we interpret the answer is essentially simple: the shorter
the time frame an investor has, the less they should have allocated to
the stock market. This seems counterintuitive to certain investors, who
consider themselves very aggressive, monitor their performance daily, and
think that they should be 100% in equities all the time.
The problem is that the more frequently they check their returns, the more
likely they are to encounter periods when their all-equity portfolios are
showing losses (some times large ones), increasing the odds that they will
soon be 100% out of equities!
While this approach may work for some, for most investors it probably won’t.
As Jonathan Clements noted in a recent Wall Street Journal article, How Wild
a Ride Can You Handle?: “Don’t check your portfolio so frequently.
Research suggests that the more often investors look at their results, the
more [overly] cautious they tend to be.”
To illustrate these points let’s examine the returns of three broad
asset classes over the past 20 years (7/31/87 – 6/30/07) — the
U.S. stock market (S&P 500 Index), the U.S. bond market (Lehman Aggregate
Bond Index) and high-quality short-maturity bonds (Lehman U.S. Government
1-3 Year Bond Index) — under different time horizons as shown in the
table below:
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