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Feb 2, 2015

Harvesting Noise; Or: So, You Think You’re A Long Term Investor?

by David Ensor

David EnsorMost individuals would be ratherboffended if they were characterized as “speculators” rather than “investors”. Even though the world’s financial systems need speculators to function efficiently and enable price discovery, I doubt whether you, Dear Reader, would wish to be told that you were, in fact, speculating rather than investing.

So, consider this. The world’s most well-known and respected investor, Warren Buffett, describes his expected holding period for equities as “forever”. That may be something of an exaggeration, but if one looks at the largest holdings of Berkshire Hathaway they have generally been held for years, if not decades; and, of course, Berkshire Hathaway buys publicly-quoted businesses and rarely, if ever, sells them again. Of course, we are still within the span of one human being’s lifetime—let us say an “investment horizon” of 70 adult years—yet there are entities which invest for “forever”, at least in human terms, such as university endowments. In the US the socalled “Yale model,” focused on illiquid markets and asset classes is prevalent, at least in the upper echelons of scale and sophistication, but in the UK, some endowments do, literally, buy and hold “forever”, maintaining ownership of assets such as agricultural land, commercial property and even equities for generations.

Contrast this with the late, unlamented “day traders” or the algorithmic and hyperactive “high-frequency traders” (HFTs) described in Michael Lewis’ Flash Boys, for whom a millisecond is a long time.

Then consider the purpose and characteristics of your own “investing”. What is your own investment horizon? Do you really invest for the long term, or are you guilty of making obeisance to the false gods of the investment management industry, whose real motivations, in many cases, are to accrue assets in order to generate higher fees, and to avoid moving too far away from the relevant benchmark in terms of performance, because that might require explanation and make its perpetrators vulnerable to job loss. In reality, almost all investment managers churn the contents of the portfolios they manage several times a year, by which I mean that their average holding period for an asset is often well under 12 months. Is that really long term, or are they instead “harvesting noise” as prices in the markets rise and fall?

And what of passive index investing? No sane person should do this through any other mechanism than the lowest cost, most efficient provider (while ensuring that the index tracking error is as small as possible); but is even that a “long term” investment (assuming that you simply buy it and then hold it), given that most indices are adjusted and re-balanced periodically, sometimes as often as quarterly. Thus, at least at the margin, even that favourite S&P 500 ETF or FTSE 100 ETF which you own is subject to market noise, as share prices rise and fall and companies are ejected from or added to an index. This is not to say that you should not, almost invariably, prefer such an approach to that of the active manager doomed to underperform even the average (and charge absurd levels of fees for doing so), but simply to point out that “noise” is ever present, when what you are really looking for are signals that communicate whether or not continuing to hold a particular asset makes sense.

Where does all the previous discussion leave us? What is long term investing? How long should your investment horizon be; and how might you avoid the noise and distractions of the market? A simple definition of long term investing might be owning a specific asset with the intention of generating income from it (usually through dividends), and/or realizing value from it when the purpose for which the investment was made comes to fruition, or cash is needed for a particular purpose. As for your investment horizon, it probably makes sense to divide that into “time buckets” because there is a difference between investing to build, say, the funds for downpayment on a house, investing to send your children to university, and investing for a hoped-for retirement 30 or 40 years hence. Each is a specific goal, but their horizons are very different.

Having, I hope, set the framework for how one might start to think about what we really should describe as the long term (as opposed to what the “market” would have you believe), in my next article, I shall develop the concept further, and suggest some potential approaches to such an investment period.

David Ensor: Risk Management Consultant;