One of the biggest challenges facing individual investors is that of time frame. Individual investors have the benefit of having a longer term time horizon than institutional investors. The problem is that individual investors squander those advantages by trying to play the same game the big boys play. Unfortunately institutional managers are already following sub-optimal strategies due to the business risks of undergoing extended periods of underperformance. In so doing they shorten their time horizon to fit that of their unduly anxious clients. This mismatch in time horizons that is noted in a new paper.
A recent research paper by Andrew Ang and Knut N. Kjaer delved into the topic of investor time horizons in “Investing for the Long Run.” The paper is worth reading in part because it is not particularly long or technical. In this paper they look at the many advantages that long term investors have and the ways in which they these investors fritter away these advantages. One way in which investors fritter away this time advantage is by engaging in “procyclical investments.” In short, they buy high and sell low. One way recommended in the paper for investors to offset this tendency is “institutionalize contrarian behavior.” This can be done in part by having a formal reblancing process that by its nature sells those assets that have been outperforming.
Another thing that investors with a sufficiently long time horizon can do is build a portfolio that exploits certain factors. There is a large literature of factors that seem to generate abnormal returns. Combining them in a portfolio can yield more consistent returns that one solely focused on asset classes. This ability is one of the ways that investors with a long time horizon can exploit. Ang and Kjaer write:
Long‐horizon investors have an edge. They have the ability to reap risk premiums that are noisy in the short run and only manifest over the long run. They can acquire distressed assets when investors with over‐stretched risk capacity have to sell. They can also pursue opportunities to invest in illiquid assets.
The challenge for investors is recognizing what sort of time horizon they should have. (The long run may in fact be shorter than we think.) Changing time horizons, by turning trades in investments and investments into trades, is a common enough problem that investors should always be on the lookout for this type of behavior in their own portfolios. In an investment world filled with machines trading with other machines the long run seems to be the one place where disciplined individual investors may in fact have a edge.
Items mentioned above:
[earlier] Business risk and the risk of underperformance. (Abnormal Returns)
[earlier] Playing a different game. (Abnormal Returns)
“Investing for the Long Run” by Andrew Ang and Knut Kjaer. (SSRN via CXOAG)
[earlier] The behavior gap illustrated. (Abnormal Returns)
[earlier] Diversification, rebalancing and commitment. (Abnormal Returns)
“Strategic Allocations to Premiums in the Equity Market” by David Blitz. (SSRN)
“Time Horizon Trading and the Idiosyncratic Risk Puzzle” by Juliana Malagon, David Moreno, and Rosa Rodriguez. (SSRN via All About Alpha)