Tuesday, September 16, 2014

Two Sidelights on Short-Termism

I've often referred to the empirical work of Haldane & Davies and the theoretical work of Farmer and Geanakoplos, both of which suggest that investors using Discounted Cash Flow (DCF) to decide whether an investment now is justified by returns in the future are likely to undervalue the future. This is a big problem in areas, such as climate change and digital preservation, where the future is some way off.

Now Harvard's Greenwood & Shleifer, in a paper entitled Expectations of Returns and Expected Returns, reinforce this:
We analyze time-series of investor expectations of future stock market returns from six data sources between 1963 and 2011. The six measures of expectations are highly positively correlated with each other, as well as with past stock returns and with the level of the stock market. However, investor expectations are strongly negatively correlated with model-based expected returns.
They compare investors' beliefs about the future of the stock market as reported in various opinion surveys, with the outputs of various models used by economists to predict the future based on current information about stocks. They find that when these models, all enhancements to DCF of one kind or another, predict low performance investors expect high performance, and vice versa. If they have experienced poor recent performance and see a low market, they expect this to continue and are unwilling to invest. If they see good recent performance and a high market they expect this to continue. Their expected return from investment will be systematically too high, or in other words they will suffer from short-termism.

Yves Smith at Naked Capitalism has a post worth reading critiquing a Washington Post article entitled America’s top execs seem ready to give up on U.S. workers. It reports on a Harvard Business School survey of its graduates entitled An Economy Doing Half Its Job. Yves writes:
In the early 2000s, we heard regularly from contacts at McKinsey that their clients had become so short-sighted that it was virtually impossible to get investments of any sort approved, even ones that on paper were no-brainers. Why? Any investment still has an expense component, meaning some costs will be reported as expenses on the income statement, as opposed to capitalized on the balance sheet. Companies were so loath to do anything that might blemish their quarterly earnings that they’d shun even remarkably attractive projects out of an antipathy for even a short-term lowering of quarterly profits.
Note "Companies were so loath". The usually careful Yves falls into the common confusion between companies (institutions) and their managers (individuals). Managers evaluate investments not in terms of their longer-term return to the company, but in terms of their short-term effect on the stock price, and thus on their stock-based compensation. Its the IBGYBG (I'll Be Gone, You'll Be Gone) phenomenon, which amplifies the underlying problems of short-termism.

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