How To Avoid The Problem Of Short-Termism

If I had to pinpoint the biggest problem for most asset allocators I would probably say short-termism. Short-termism is the tendency to judge financial markets in periods that are so short that it results in higher fees, higher taxes and lower average performance. We’ve become accustomed to judging the financial markets in quarterly or annual periods which contributes to this short-termism, but some context will show that this makes very little sense.

This has become an increasingly problematic reality for the modern asset allocator as we are bombarded with investment options, the 24 hour financial news cycle and are regularly told that we’re stupid if we can’t “beat the market” (even though 80%+ of the pros consistently fail to beat the market also). The result has been a dramatic decline in the average holding period of stocks. In 1940 the average stock was held for 7 years, whereas today the average stock is held for 1 month! As I’ve noted before, I suspect all of this information and “news” is actually making us worse investors as it’s feeding on our behavioural biases.

The arithmetic of global asset allocation clearly shows that more activity leads to higher taxes, higher fees and lower average returns, however, asset allocators are constantly falling victim to the myth that more activity leads to more control or better results. In fairness, this short-termism is understandable. No one likes to work for years earning their savings only to see it decline in value as the markets shift daily, monthly and annually. So, how can we be better prepared to overcome the problem of short-termism? You just have to arm yourself with a bit of knowledge regarding the process of asset allocation so you put the problem of time in the proper context.  

As I noted in my new paper on portfolio construction, the allocation of savings is ultimately about asset and liability mismatch. Cash lets us protect perfectly against permanent loss risk and maintain certainty over being able to meet our short-term spending liabilities, however, because it loses purchasing power it leaves us exposed to this risk in the long-term. Cash feels safe in the short-term, but in the long-term it is the riskiest asset because it is guaranteed to decline in value relative to inflation. We can extend the duration of our financial assets to better protect against the risk of purchasing power loss, however, this increases the odds of permanent loss risk (the risk of being forced to take a loss at an inopportune time) and not having the funds when you need them.