Have investors become too impatient? That’s the question posed by Andy Haldane, head of financial stability at the Bank of England in a recent paper.
Haldane notes that, as humans, we’re torn between patient and impatient impulses. It’s not surprising then that we see this same conflict in our economic behaviour.
Haldane notes that in economic theory, patient behaviour yields the greatest rewards. Patient households generate savings that companies use to finance their investments. And future economic growth comes about as a result of firms building up their capital.
But economists recognise there are occasions when impatience gets the upper hand, and people prefer instant gratification instead of savings. Economic theory says that low savings rates are associated with lower rates of long-term investment and growth. As Haldane puts it, “some jam today would come at the expense of a whole jam-jar tomorrow.”
But are there signs that, as a society, we’re adopting a more short-term, impatient approach when it comes to investing?
One way to measure this is to look at share prices and compare them to expected future profit streams. You’d expect in a market that was dominated by patient investors that asset prices would tend to reflect underlying fundamentals. But where impatient, momentum traders dominate the markets, you’d expect asset prices to become more volatile, and to deviate more from expected future profits.
And that’s exactly what’s happened. Haldane says “on average over the past century, US stock prices have been over three times more volatile than fundamentals”.
What’s more, share price movements are becoming much more volatile. “Up until the 1960s, prices were around twice as volatile as fundamentals. Since 1990, they have been anywhere between six and 10 times more volatile. Excess volatility in equity prices has risen as financial innovation has taken off.”
And the extent to which share prices are diverging from fundamentals has exploded. “Up until 1960s, the average absolute deviation of US equity prices from fundamentals was just over 20%. Since 1990s, the average absolute deviation has been well over 100%… Misalignment correlates with innovation and liquidity. “
If impatience is growing, you’d also expect that investors would become more short-term in their outlook, holding their financial investments for shorter periods of time. Again, that’s exactly what we’ve seen.
“In 1940, the mean duration of US equity holdings by investors was around 7 years. For the next 35 years up until the mid-1970s, this average holding period was little changed. But in the subsequent 35 years average holding periods have fallen secularly. By the time of the stock market crash in 1987, the average duration of US equity holdings had fallen to under two years. By the turn of the century, it had fallen below one year. By 2007, it was around 7 months. Impatience is mounting.”
And it’s not only US investors who are becoming increasingly impatient. A similar trend is underway in all major international markets. Typically investors hold shares for less than one year. For the Shanghai stock index, the average holding period is closer to six months.
One of the reasons that investors are turning over their investments much more rapidly is that the cost of buying and selling shares has fallen dramatically.
But, as Haldane notes, this drop in trading costs has also spurred the growth of a new class of investor – the high-frequency traders (HFT).
According to Haldane, “while HFTs are not new, their speed of execution has undergone a quantum leap. A decade ago, the execution interval for HFTs was seconds. Advances in technology mean today’s HFTs operate in milli- or micro-seconds. Tomorrow’s may operate in nano-seconds.”
These new traders are increasingly dominating the market. Haldane notes that HFT firms are now believed “to account for more than 70 per cent of all trading in US equities, 40 per cent of volumes in US, 40 per cent of volumes in US futures and 20 per cent of volumes in US options. In Europe, HFTs account for around 30-40 percent of volumes in equities and futures. These fractions have risen from single figures as recently as a few years ago. And they look set to continue to rise.”
But the growing dominance of HFTs is exacerbating market turbulence. Haldane points to the ‘flash crash’ in May this year when the prices of 200 shares fell by more than 50 per cent in a 45-minute period, even though there was no significant political or economic news.
Even now the cause of this ‘flash crash’ is still not clear, but “it is known that a number of large HFT trading positions coincided with these chaotic dynamics. In response, market-makers and liquidity-providers withdrew.”
According to Haldane, this was an instance when “trading in securities generated trading insecurities. The impatient world was found, under stress, to be an uncertain and fragile one.”
But there are other signs that of investors are increasingly demanding instant gratification. Companies now routinely offer high dividend payout ratios, and maintain their dividends even when their profits have declined. Also CEOs – who face tough scrutiny from the capital markets – are finding that their tenure in their jobs is much shorter. According to Haldane, “In 1995, the mean duration of departing CEOs from the world’s largest 2,500 companies was just less than a decade. Since then, it has declined. By 2000, it had fallen to just over eight years. By 2009, it had fallen to around six years. This pattern is replicated across regions, but is marked in North America and non-Japan Asia.”
But Haldane argues that investors, who repeatedly flip their investments, pay a huge price for their impatience.
“To illustrate some of the benefits of pre-commitment and long-duration investment, imagine having placed that $1 stake in 1967 with an investment firm whose motto was ‘our favourite holding period is forever’. By 2009, that long-term investor’s stake would have risen to $2650. Over the same period, the momentum traders’ stake would have returned $75. Buy-and-hold would have out-performed bought-and-sold by a factor of around 36.”
As a result, he says, it may be necessary to implement measures to foster investor patience, such as offering incentives to investors who hold assets for longer periods of time, or longer-term savings schemes.
“It is important finance sticks to the patient evolutionary path. To do so, the fidgeting fingers of the invisible hand may need a steadying arm.”
This article first appeared on Business Spectator.
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