How the waiting game will favour patient investors
Patience is a virtue in so many aspects of human endeavour, so how do you harness it to create more stable and better-functioning financial markets?
That is the theme of a speech to be made this Thursday by Andy Haldane, the executive director at the Bank of England in charge of financial stability.
The nub of his argument is that finance can develop in two ways. In one, patience becomes self-reinforcing, so that financial liberalisation encourages better investment decisions and unleashes economic growth.
In the other, impatience also becomes self-reinforcing, encouraging over-trading and under-investment. For countries that have already liberalised their financial systems, “the choice is how to promote patience while harnessing impatience”.
We know that some people have deeply destructive habits but we also know that people can be nudged into self-improving behaviour. He cites a study that showed that if people are given a small financial inducement to go to a gym that radically changes their fitness behaviour.
So how do you encourage patience in finance? China, he argues, is on a self-improving cycle. To head down such a path you need liquidity and information. But too much of these encourages excess: excess trading, excess credit and excess volatility. The debate about this leads into a series of puzzles, which one could sum up in the question: “Why are markets so inefficient?” Prices swing far away from the levels justified by fundamental economic conditions and as a result markets make mistakes in allocation of resources.
But there is a problem, a big one. You might imagine that, in terms of investment, patience should win out. Investors that follow the commonsense fundamental approach of buying when shares are low relative to economic fundamentals and selling them when they are high should do better than the speculator who buys when shares are rising and sells when they are falling. That isn't the case. Imagine two investors, each investing $1 in US equities in 1880. The fundamentalist, who bought when shares were low and sold when they were high would have found his or her stake falling to 11 cents by 2009. The speculator, the one bought when they were rising and vice versa, would have more than $50,000.
There seems to be a built-in incentive to chase share prices up when they are rising and chase them down when they are falling. This is an obvious recipe for volatility.
There has been a surge in high-frequency trading – racing in and out of stocks in micro-seconds. In the past year or two, the scene has been transformed by the rising speed of execution.
And the message for investors? It is true that over the past 120 years a US investor would have been better to follow a speculative strategy than a value one.
But Dr Haldane notes that if you invested $1 in 1967 in an investment company whose motto is “our favourite holding period is forever” it would by 2009 be worth $2,650. If you invested it in the markets generally it would be worth $75. So maybe a “buy and hold” strategy is not such a bad idea. You can work out which investment company it is for yourselves, but I will give you a hint. Its founder hails from Omaha.