The inherently short-term nature of the investment management industry

Human foibles

Coping with stress and anxiety

In this post I want to weave together two related ideas. The first is the need for investors to make decisions based on long term thinking which is in a constant struggle with our urge to act in a short term fashion.

The second is stock market volatility caused by investors’ short term actions which I will call silliness. They are acts of poor judgement.

Not all stock market volatility is caused by investor silliness. But, a large part is.

And, once we get these thoughts straight in our brains, intelligent investors can take advantage of other investors’ silliness.

The evidence

William A. Ackman is an American billionaire investor and hedge fund manager. He is the founder and CEO of Pershing Square Capital Management, a hedge fund management company.

In his August 16, 2022 Investment Manager’s Report to shareholders of Pershing Square Holdings, Ltd., he wrote:

“The inherently short-term nature of the investment management industry is a large contributor to stock (and bond) market volatility. As many funds suffered substantial drawdowns earlier this year, they sold stocks to raise capital to meet redemptions, and reduced market exposure as their risk appetites declined. This pattern of reducing equity market exposure as stock markets decline occurs in every market disruption, but it is precisely the opposite of what long-term investors should do. It is axiomatic that the lower the price paid, the better one’s long-term returns. Yet, in each crisis and/or market drawdown, fund managers sell and reduce exposures, rather than increase exposures at more favorable valuations.” (Emphasis added)

Ackman tells us that the selling pressure came from institutions. He points out that “most investors in funds are fiduciaries who are themselves held to short-term measurements of their own performance.”

To read the Pershing Square report see here.

So the silliness came from the investment industry. No doubt some silliness also came from individual investors. Together, this silliness was enough to move the market.

As their risk appetites declined

I recall the late 1990s when the Dot Com boom was in full swing. A lot of money was invested in themed mutual funds that focused on ‘dot com’ tech stocks. The fund managers were obliged to invest any new money coming into the fund in ‘dot com’ tech stocks regardless of the investment merits of the companies. The late 1990s was a time of increasing risk appetites and of increasing silliness. Of course, once the dot com bubble burst, the market started going down. It became a period of declining risk appetites and also a time of increasing silliness. The themed tech funds experienced redemptions and the fund managers were obliged to sell to cover the redemptions. There was a massive amount of silliness in the stock market in that period.

The psychology behind this

Warren Buffett is reported to have told Congress on June 2, 2010: “Rising prices are a narcotic that affect the reasoning power up and down the line.” (Marks, The most important thing illuminated: uncommon sense for the thoughtful investor. 2013) p.101  (emphasis added)

The flip side of this is that declining prices are like a drug that induces stress and anxiety.

George Soros is chair of Soros Fund Management LLC. He is one of history’s most successful financiers. He has already donated $32 billion of his fortune to charity. He weighs in on this same phenomenon. It is one of his favorite topics. Soros writes:  “Rising prices often attract buyers and vice versa.” (Soros, The Crash of 2008 and What it Means, 2008,2009)p.56. [emphasis added]  What he is saying is that buoyant stock prices can cause investors to become more bullish thus increasing stock prices even if the fundamentals don’t change. He explains this further in an earlier book. (Soros, The Alchemy of Finance, Reading the Mind of the Market, 1987,1994) pp. 50-54.

Howard Marks is the co-founder and co-chairman of Oaktree Capital Management, the largest investor in distressed securities worldwide. He explains: “We learn in Microeconomics 101 that the demand curve slopes downward to the right; as the price of something goes up, the quantity demanded goes down. In other words, people want less of something at higher prices and more of it at lower prices. Makes sense; that’s why stores do more business when goods go on sale.

It works that way in most places, but far from always, it seems, in the world of investing. There , many people tend to fall further in love with the thing they’ve bought as its price rises, since they feel validated , and they like it less as the price falls, when they begin to doubt their decision to buy.” (Marks, 2013) p.27.

There is nothing new about this. In 1935 Gerald Loeb wrote about the forces behind market swings: “Market conditions are fixed only in part by balance sheets and income statements; much more by the hopes and fears of humanity; by greed, ambition, acts of God, invention, financial stress and strain, weather, discovery, fashion, and numberless other causes impossible to be listed without omission.”

He adds, “Even the price of a stock at a given moment is a potential influence in fixing its subsequent market value. Thus a low figure might frighten holders into selling, deter prospective purchasers, or attract bargain seekers. A high figure has equally varying effects on subsequent quotations.” (Loeb, The Battle for Investment Survival 1935, 2007) p.2.

He is talking about the behavior of investors as human beings. He is talking about investors’ capacity for silliness.

Conclusion

It has been drilled into our brains as investors that we have to think and act for the long haul. There are aphorisms like ‘it’s time in the market not market timing’ and so on. Yet, when the market is on a roll it can act as a ‘narcotic’. We become risk seeking. When the stock market is in the dumper, it induces anxiety and stress. Our risk appetite plunges. We become risk averse.

The message is this. At a time of substantial drawdowns most investors are doing “precisely the opposite of what long-term investors should do.” They are a large contributor to the drawdown.

It is at such times that intelligent investors are able to “increase exposures at more favorable valuations”.

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Other posts on investment psychology

This post is part of a series. Readers are invited to read Investment psychology explainer for Mr. Market – introduction This will give you a better understanding of some of the terms and ideas and give you links to other posts in the series.

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To read more about coping with short term volatility you might check out this post:

Overcoming mistaken short term thinking with Kahneman style risk policies

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You can reach me by email at rodney@investingmotherlode.com

I’m also on Twitter @rodneylksmith

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Check out the Tags Index on the right side of the Home page that goes from ‘accounting goodwill’ to ‘wisdom of crowds’. This will give readers access to a host of useful topics.

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You can also use the word search feature on the right hand side of this page to find references in both blog posts and also in the Motherlode.

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There is also a Table of Contents for the whole Motherlode when you click on the Motherlode tab.

Want to dig deeper into the principles behind successful investing?

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