A common criticism that is levelled at investors is that they are too short-termist in their outlook.
It represents a topic that RC Brown Investment Management’s Glenn Meyer, who is head of managed funds, was keen to explore. He suggests that ‘myopic loss aversion’ may well lie at the heart of this problem. This theory explains why the equity risk premium (which is the return required for investing in ‘volatile’ equities instead of ‘risk-free’ bonds) can be high; namely, because capital allocators tend to focus on the risk of losing money when they consider the risk/return trade-off over short investment periods. In other words – they focus on the risk of losing money and therefore demand a higher potential return to compensate them.
In Glenn’s opinion, it isn’t necessarily a bad thing for professional investors to demand a high equity risk premium to compensate them for high volatility. Here’s why…
“We are delighted to bank these incremental returns for our clients. For us, volatility is not a complete or adequate descriptor of risk and we continue to define risk as ‘the chance of suffering a permanent loss of capital’.
“In short, we want to have exposure to good stocks with growing profits, which won’t go bust and to hang on to them for the long term,’ Glenn explained.
Looking beyond short-term returns
In the investment manager’s opinion, one possible solution to ‘myopic loss aversion’ could be for investors to stop looking too closely at the returns generated by their portfolios over the short-term. He points to a paper that was written by a PhD student Maya Shaton in 2010, which found that when the Israeli regulator changed the order in which the returns on a fund were presented there was an effect on investor behaviour.
“Previously the first number shown was the return for the most recent month, but post the new regulation the return on the past year was shown first. This had the effect of causing investors to shift more of their assets into equities. They also traded less often and were less likely to buy into funds with high recent returns.
“It would appear that although Israel has been accepted as a contributor to European culture by competing in the Eurovision Song Contest, European financial regulators do not yet want to share the ideas of the Israeli regulator,” he said.
In fact, Glenn believes that the introduction of quarterly reports with MiFID II in January of this year (superseding half yearly reporting) represents a retrograde step by the European regulator. This is because it runs the risk of making investors and clients too short-termist in their outlook.
With this in mind, RC Brown has decided to keep three of its new-style reports reasonably short; the plan is for the fourth report to provide more detail, with a focus on longer term activity and performance.
“The reason for this is not just laziness on our part but is rooted in sound behavioural finance principles,” Glenn concluded.
This is a view that we agree with here at DISCUS. We can only hope that short-termism isn’t one of the unintended consequences of MiFID II.