Short-term Thinking Magnifies Risk

We always talk about the harm short-term thinking can inflict on your investment portfolio. Now, a new study from Professors Francois Brochet, Maria Loumioti, and George Serafeim at Harvard Business School further explores the risks for companies and investors who are attracted to short-term results.

Not surprisingly, their research shows that companies with short-term mindsets attract short-term investors looking for quick payouts. This naturally puts pressure on the company’s executives to generate positive returns, and short-term oriented corporate managers are therefore more likely to take risks to deliver the performance their investors demand. In fact, the short-term companies studied had more volatile stock returns and higher estimated cost of equity capital, two characteristics that make them riskier than companies with longer-term investment views.

It follows, then, that investors looking to temper the volatility of their portfolio should consider the short- and long-term goals of the company before they invest. But just how does one determine whether a company thinks long- or short-term? The Harvard professors studied transcripts of 70,042 earnings calls held by 3,613 firms from 2002 to 2008. They searched for 14 terms used by management such as "latter half" and "weeks" that would suggest a short-term view, versus 15 words or phrases such as "long term" and "years" that likely would dictate a longer time horizon.

Harvard Business School Assistant Professor George Serafeim said one important takeaway from his research is that many companies are, in fact, being managed for the long term. he noted. According to the researchers, industries focused on long term include beverages, retail, pharmacy, and medical goods. In particular, they singled out Coca-Cola, Ford, and Nordstrom as long-term thinkers. Short-term-oriented industries included banking, electronic equipment, business services, and wholesale, with Cisco, Goldman Sachs, and Chevron on the short list.

Of course, investors should still focus on building a diversified portfolio with the proper allocation based upon their goals and risk tolerance.

Just What is the Fiscal Cliff?

The ominous term “fiscal cliff” has crept into our lexicon, but just what does it mean? The fiscal cliff is a perfect storm of disastrous events that could push our recovering economy back into recession. First, there’s the scheduled expiration of the Bush tax cuts at the end of this year. Additionally, our economy will need to absorb automatic cuts to the federal budget, including significant reductions in defense spending mandated by last summer’s agreement to raise the U.S.’s debt ceiling. Finally, our national debt continues to spiral out of control and Congress finds itself stymied by partisan gridlock.

Focusing on doom and gloom, magazine covers feature pictures of the Capital Building slipping off the cliff. But this is not just media hype. Last week, the nonpartisan Congressional Budget Office (CBO) issued a report warning that the economy will indeed enter a recession next year if the country goes over the so-called fiscal cliff. According to the CBO, the economy would contract by 0.5 percent in calendar year 2013 if the Bush-era tax rates expire and automatic spending cuts to the federal budget are implemented. Further, the CBO estimates that unemployment also would rise from 8.2% in 2012 to 9.1% next year.

Federal Reserve Chairman Ben Bernanke has underscored the dangerous impact of the fiscal cliff, warning that “there is absolutely no chance that the Federal Reserve would be able to have the ability whatsoever to offset that effect on the economy.” Notably, over the course of the last few months, Chairman Bernanke’s warnings have become more dire. In April, he noted that “a sharp fiscal tightening could occur at the start of 2013” that could lead businesses to defer hiring and investment. Yet, minutes from the Fed’s July 31-August 1 meeting describe “a sharper-than-anticipated U.S. fiscal consolidation” as a “significant downside” risk to our economic outlook.

In the CBO report, Director Doug Elmendorf urges Congress to act in September to avoid the fiscal cliff, reasoning that the sooner uncertainty was resolved, the better for our economy. However, Congressional action is highly unlikely given the magnitude of the task and the distraction of a polarizing Presidential campaign. I hope that one day soon the importance of our nation’s fiscal health can transcend politics and that Congress and the President can reach an agreement. And for the sake of our fragile economy, let’s hope that day comes sooner rather than later.

However, despite this news an investor should not abandon their long-term investment strategy.  The pundits have been wrong before and it is more rational to stick to one's long-term plan than to abandon it on what "might" happen.  Furthermore, once an investor abandons his or her plan he or she must decide when to reactivate the plan.  And by the time that decision is made most investors would have been better off if they had stuck to the plan.

Stick with Stocks

Many investors believe step one in dialing down their portfolio’s risk should be reducing equity exposure. Yes, stocks are riskier than bonds, but that’s an oversimplification that can result in some misguided moves. First, stocks provide a greater return than bonds over the long term According to Standard & Poor’s, the S&P 500 Index has had an average annual return of 9.9 percent annually from 1926 to 2010. Over the past 50 years, it’s returned 9.8 percent, and over the past 25 years, the return has been 9.9 percent. According to Ibbotson Associates, long-term government bonds have averaged 5.5 percent, 7.1 percent, and 8.9 percent during these same three time periods.

Stocks are also a better hedge against inflation. On an inflation-adjusted basis, the S&P 500 Index has provided average annual returns of 6.7 percent from 1926 to 2010, 5.4 percent over the past 50 years, and 6.9 percent over the past 25 years. There were a total of 10 rolling-year periods when the S&P 500 Index did not keep up with inflation. While long-term government bonds provided inflation-adjusted returns of 2.4 percent, 2.9 percent, and 5.9 percent over those same three periods, there were 33 rolling-year periods when long-term government bonds did not keep up with inflation. One factor influencing the gap between stocks and bonds is that, even in difficult markets, companies can increase their prices to remain competitive.

If you want another reason to invest in equities, consider this prediction by Professor Sylla, a financial historian at New York University's Stern School of Business who has studied market behavior all the way back to 1790. A recent Wall Street Journal article--A Long-Term Case for Stocks--reported his view that if the market sticks to its long-term pattern, the Dow Jones Industrial Average could climb to 20250 by the end of 2020, up 84% from its recent 10992. Additionally, he says the Standard & Poor's 500-stock index might hit 2300, up 99% from its recent close of 1154.23.

Using 10-year averages of annual market returns, including dividends and adjusting for inflation, Prof. Sylla found when 10-year-average annual returns drop below 5% as they did in 2008 and 2009, markets tend to transition to recovery.

Of course, we all know that past results cannot be used to guarantee future returns…

The real lesson in this research is that investors are best served when they take a long-term view of the market and think in terms of decades and years, not quarters.