My mechanical portfolio experiment has got me thinking more about the dimension of time. Investing is basically a race, more of a marathon than a sprint, but a race nonetheless. Like all races, minimising the time taken to get from A to B is the thing that matters the most. If you didn’t care how long it took to generate returns, you would keep your money in a low risk savings account. We all understand this, but we often don’t pay so much attention to the time dimension in practice. Thinking about the time dimension more explicitly can help you to deal with a notoriously difficult part of investing strategy – how frequently and in what circumstances should you sell?
Time is opportunity
Thinking about investments in terms of their financial outcomes comes quite naturally to most investors. An investment that results in you doubling your initial stake feels more successful than one where you only make a 50% return. However, this is not always the case – it also matters how long it takes to achieve these returns and what your alternative options were. Fundamentally, investing is about getting the most out of two scarce resources, your time and your money. Time matters because it represents lost opportunity. The time spent waiting for an investment to come good costs you the opportunity that you could be invested in something better.
Properly accounting for the time taken for investments to yield returns and how this compares to alternative investments is often relatively neglected. Our natural tendency is to default to thinking simplistically in terms of success and failure and to pay less attention to how long it takes or what other options were available. The idea of success vs failure is a powerful motivator, while other more esoteric concepts are less so.
Rather than simply success or failure, investing should more accurately be about maximising performance over time, taking account of the opportunities available. You are free to reassess the relative merits of investments and switch horses whenever you want at fairly low cost. You need to judge when it’s right to trade and when it isn’t: when should you sell on apparently temporary bad news? How much price volatility should you put up with before selling? When should you ditch a more steady holding for something racier in a bull market?
A framework that weighs up alternative investment opportunities against one another on an ongoing basis can help you answer these questions without your emotions getting in the way. I am a recent convert to using periodic rotation rather than stop losses. This seems more in line with the idea of continually optimising my portfolio’s performance rather than worrying about individual trades.
What is the right time horizon?
To weigh up investments against one another, you also need to be clear about the length of time you expect to hold them – your ‘time horizon’.
I’ve seen time horizon used to mean different things, so a clarification is in order here. By time horizon, I mean the period over which you care about the likely return of an investment when you first invest. This doesn’t necessarily mean you end up holding the investment for that long – you can change your mind and hold for shorter or longer depending on what happens. It should also not be confused with how far into the future you look when assessing the value of an investment – the right answer to that is ‘forever’ (or as long as possible). Obviously, this doesn’t imply you would necessarily want to hold that investment forever.
Different investing strategies suit different time horizons, depending on what factors they target. Your time horizon, along with how much volatility you will tolerate and in what circumstances you will sell should be calibrated by your initial investment thesis.
At one extreme, you have Buffett-like strategies that rely only on fundamentals and aim to hold on to investments ideally forever. With a very long term horizon, all you should really care about is the certainty and extent of long term growth, i.e. quality, and to a lesser extent the starting valuation. It’s only really worth swapping horses if this fundamental story changes i.e. only if bad news looks to be permanent rather than temporary, or if changes in relative valuations are material enough to make an alternative prospect seem clearly more attractive over the long term. This should happen fairly rarely. This approach to investing has a lot to be said for it. It is logically robust and has the advantage of massively simplifying decision-making and reducing the scope for emotions to cause mistakes. However, it also seems unsatisfyingly far from optimal.
Using a shorter time period is intrinsically better in that it makes use of your ability to make decisions and compound your returns more frequently. Share prices year to year are volatile – even those of very high quality businesses don’t go up in a straight line. If you can predict the direction of price movements over a year with any accuracy, then exploiting this again and again, for example by following momentum, is inherently more valuable than only making a single prediction over the very long term. High portfolio turnover is a positive as long as your trading decisions add rather than subtract value. However, you are limited from using time periods that are too short by a couple of factors. Trading costs mean that it is too expensive to optimise your portfolio all the time and over shorter time periods the direction of price movements becomes more random and less predictable anyway. There is a balance here to be struck.
The key thing is to make sure your time horizon matches up with the factors your strategy targets. Too short a time horizon and you risk overtrading, while too long a time horizon may mean you allow too much volatility and risk substantial losses if you are wrong.
In striking this balance, the answer I’ve got to is a time horizon of about a year. Even though I think the very long term is the most valuable perspective in investing, it seems to me that a year is likely to be a better time horizon than forever. The reason is simply that there is a weight of evidence that factors other than just long term quality, e.g. value or momentum, are partially effective in predicting returns over about a year. If you can successfully add these factors into the mix, then you should have a strategy that dominates a simple ‘buy and hold quality until the story changes’ strategy.
For time periods of much shorter than a year, say three months or less, momentum works less well. The directions of price movements are much more random and less predictable. Perhaps you can have some success with an approach based on technical analysis but this is outside my circle of competence. The danger for me with my current strategy is getting drawn in to worrying too much about short term volatility, when the factors I am targeting aren’t so good at predicting very short term price movements. As a result I can end up changing my mind too frequently and overtrading. This is a reason why I now prefer the discipline of periodic rotation to leaving it all to discretion.
About the future, not the past
I find it interesting that many investors treat the decision to continue to hold an investment differently to the decision to buy a new one.
This is quite explicit in some strategies, for example where shares are only bought when they are sufficiently ‘cheap’ but with the aim to hold them forever, i.e. even when they get expensive. Some of my favourite investors, like Warren Buffett and Terry Smith seem to espouse this in their strategies. This approach can seem intuitively attractive, but there is a logical fallacy at the heart of it. If it makes sense to continue to hold an investment at the current market price, then it should also make sense to buy it if you don’t already hold it. Either you should be prepared to pay higher valuations when originally making investments in high quality businesses, or you should be trading frequently based on relative valuations. Treating buy decisions differently to hold decisions doesn’t make much sense.
Another similar example is applying a strict stop loss when originally buying an investment, but then relaxing it when the investment is in significant profit. There isn’t a very logical reason for treating these situations differently – the only difference is the price you originally paid. The market doesn’t care what price you initially paid or whether you are in profit. Logically, neither should you when setting your stop loss.
Thinking otherwise is known as the sunk cost fallacy. Costs that are sunk, i.e. have already been incurred and cannot be recovered, are not relevant to your current decisions. Once you own an investment you can’t change the price you paid. It is no longer relevant, so you shouldn’t let it affect your subsequent decisions. I talked about the sunk cost fallacy previously in this post, in trying to debunk the misguided idea that stop losses make sense because of the mathematics of compounding.
One reason why a decision to hold is not quite the same as a decision to buy is that there are trading costs. These mean it is marginally cheaper to continue to hold a stock than to buy it for the first time. Trading costs may affect larger investors, like Warren Buffett or Terry Smith, to a greater extent as they may not be able to sell out of large positions without affecting the price. Even so, over a sufficiently long time horizon (say of at least a year), trading costs become less relevant compared to the relative prospects of alternative investments.
Another possible justification for treating the decision to hold differently to the decision to buy is if there are psychological benefits. You could make a case for applying stop losses more rigorously to losers than winners, if you believe there is an intrinsic psychological benefit to avoiding holding losers in your portfolio. There may well be. Similarly, you might think it better to have the discipline to always hold on rather than sell in response to relative valuations, if you were prone to overtrade otherwise.
These might be significant benefits for some investors, but I prefer not to treat continuing to hold an investment differently to buying for the first time. If you want to optimise your portfolio’s performance over time, whether or not you already hold a stock should only have limited relevance as to whether you continue to hold it in the future instead of a better alternative. Of course, trading costs mean that you should limit how frequently you trade, but I think there are a better ways to do this e.g. by simply setting rules for how frequently you trade.
I recommend reading The Art of Execution. Your blog is fantastic btw.
Thanks KP yes I’ve read the Art of Execution and very much enjoyed it.