Home / Opinion / Short-termism: a flaw that diverts the investment chain

The tendency to buy when others buy and sell when others sell sets investors up for loss-making outcomes. Lure of instant gratification is a quirk of nature that drives this behaviour. This and other short-term thinking handicaps have been affecting financial markets to the considerable and collective detriment of everyone involved. The 2008 subprime crisis has numerous examples of organised and unrestrained short-termism (read profiteering), including cases of outright cheating. There has been significant and widespread value destruction that the crisis unleashed. This led to new regulations (notably, Dodd Frank Act, Volcker Rule and Basel III norms) and numerous policy changes such as the US Federal Reserve’s unconventional monetary policy that is still a work in progress. Globally, myopic short-term thinking is being questioned afresh in industry/practitioner musings as well as academic forums. “Quarterly capitalism", as it is being called, is now also a part of the US presidential campaign debate.

Quarterly capitalism

In the UK, as a result of the John Kay review on long-term decision making, there has been a significant revision in reporting requirements that companies have. From last November, FTSE companies have been exempted from quarterly earnings disclosures. It is unclear if other countries will follow. Increased disclosures were required in the first place to address information asymmetries and to prevent companies from operating from black boxes with no transparency. The disadvantages of mandatory interim quarterly reporting, therefore, will have to be carefully weighed against the value-add that such quarterly disclosures bring. It is interesting to note the historical context. Quarterly reporting originally came into effect through the US Securities Exchange Act, 1934, as a partial remedy for the excessive speculation (i.e., short-termism) in the run up to the 1929 crash and the subsequent Great Depression. In India, quarterly reporting is mandatory for listed companies. India, too, as a senior academician lamented, has a QSQT problem. QSQT, some may recognise, is an acronym for a famous Bollywood movie (Qayamat se qayamat tak) but it also summarises the tendency that some of the Indian companies have—getting caught in a quarter to quarter reporting trap (quarter se quarter tak).

Misaligned chain of interests

The ultimate investor beneficiary, in most cases, is interested in solid long-term performance. But studies show that investors, affected by day-to-day market changes, respond in counter-productive buy-high, sell-low routines. In light of changing market conditions, among others, investors often choose to switch funds at the wrong times. This sets the stage for an inevitable cascading impact. Asset managers respond and take steps for retaining and increasing their investor base. They become pressured to focus more on the short term (and lesser on the long-term value) as their selection and monitoring is often guided by their near-term relative performance. In turn, companies, influenced by the asset manager vote (sometimes asset managers choose to vote using their feet by selling the stock), instead of focusing on long-term value creation, focus more on stock price outperformance through their next quarterly earnings beat. The behavioural flaw, of being unduly influenced by short-term returns, plays a crucial role and diverts the entire investment chain away from the important value creation role that companies have.

Price discovery versus value discovery

Company disclosures that are useful to analyse the fundamental value of a company’s stock can equip investors with crucial value enhancement and discovery information. Among others, a voting process based on such information provides companies with important feedback that can help them align business direction.

Trading, short selling, and activist investing, on the other hand, are among activities that contribute more towards price discovery. Price discovery information, in contrast to value discovery, is critical for downside protection.

Mandatory quarterly earnings reports provide information that may enable investors to find out if the companies are deviating from their value creation track. But any activities that have an undue focus on short-term earnings’ management or activities that disengage companies from longer-term capital expenditure investments (among others) are counterproductive to both price discovery as well as value discovery.

The big participants–fiduciary capitalism

Investors, asset managers and listed companies are key participants in the long term versus short term debate. But long-term institutional investors and market regulators have crucial roles as well. Long term-oriented institutional investors, pension funds in particular, are naturally aligned to what their ultimate beneficiaries need: long-term returns. In fact, investors in this category may have an express fiduciary duty of care and loyalty.

Globally, such participants include, pension funds, endowments, foundations and sovereign wealth funds. The top 1,000 of these account for more than half, i.e., about $25 trillion, of the global equity market value. If these institutions act together, they would be in a comfortable position to shape financial markets into a form they desire.

Financial markets history is dotted with a number of boom bust cycles. Instant gratification and greed—biases synonymous with short-termism—are among the core behavioural traits that continue to lead markets into crises. Behavioural biases, unfortunately, are inherited and deeply entrenched through the patterns our brain cells form. Advances in fields such as neuro plasticity suggest that it is possible to overcome these flaws. The hope is that stakeholders evolve and build learning pathways to be “long-term greedy".

Shreenivas Kunte is director–content, India, CFA Institute.

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