WHITE PAPER - Our favorite holding period is forever
Investing for the long term means more than a string of shortterm investments
When the Germans fired V2s on London during World War II, the allies thought they recognized a pattern in the randomly-fired rockets. The result was panic, with the wrong conclusions being drawn. After the war, a British statistician demonstrated that all the strikes were random and complied with the laws of chance.
People are quick to see patterns and causality in totally random data and make the wrong choices as the result. For investors, this can be risky. Peter Shapiro warns in a Comgest white paper against confusing background noise, or randomness, with real signals, a phenomenon that can also occur in the financial markets.
Shapiro draws the following conclusions:
1. People often fail to realize how great a role chance plays in financial markets, particularly in the short term.
2. Admittedly, careful long-term strategies may eliminate a large percentage of the chance, but chance continues to play a major role in the short term.
A similar problem arises when evaluating investment funds. Two factors play a significant role in that process. The expected yield and the expected tracking error (the extent to which the yield deviates from the benchmark yields). Yield can be determined on an annual basis, but the tracking error is a random factor. Statistically, the more rapid the succession of evaluation moments, the less the chance of outperformance.
The point Shapiro is making is that the longer the evaluation period lasts, the more background noise is filtered out and the more clearly the signals are received. In a short space of time, chance dominates the arbitrariness of the tracking error, or the relative yield. There is therefore little point in evaluating the performances of a fund manager in the short term. Chance then plays a dominant role, while skill is decisive for long-term results.
Unfortunately, people are impatient by nature and there is a great temptation to rely on short-term data. Investors have also started focusing increasingly on the short term. While the average time for a stock to remain in a portfolio was still more than eight years in 1960, by 2010 that period had shrunk to six months! Such short-term thinking does have its price and not least in transaction costs.
‘Our favorite holding period is forever’
Long-term strategies need time to prove themselves. Warren Buffet once wrote, “When we own portions of outstanding businesses with outstanding managements, our favorite holding period is forever.”
The chance of a fund giving top performances in the short term is not much greater than that of tossing a coin. But if an investor holds his position longer, the chance of outperformance increases. Mind you, a long-term strategy also experiences periods of poor performance. This phenomenon is the rule rather than the exception. Funds that generate top performances experience interim periods in which performances lag behind.
To eliminate chance, investors have to focus on the process. Average investors chase yield and achieve only half the returns of an average fund. Badly-timed entry and exit moments weigh heavily. A long-term strategy is therefore clearly more than a string of short-term investments.
Read more in the attached white paper by Peter Shapiro, analyst at Comgest.
Peter Shapiro graduated form Colby College with a Degree in Physics and holds Master's Degrees in Acoustics from the Pennsylvania State University and Applied Mathematics from The John Hopkins University. He is also a CFA charterholder. Peter began his career as an analyst at Legg Mason Capital Management in Baltimore, Maryland and also worked at a boutique asset manager in Paris. He joined Comgest in 2013 as a US equity analyst.