The Relationship of Risk to Investment Time Horizon

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[edit] The Relationship of Risk to Investment Time Horizon

Security prices are determined second by second during the trading day in the U.S. by the traders acting at that second - not by the investors holding the vast majority of the stock. At this level of frequency of prices, a reasonable person must conclude that price changes are unrelated to any analytical derivation based on breaking news. Thus there are other factors driving price changes besides changes in company business or market wide news. The parties to the transaction may have done in-depth analysis of the fundamental factors but this analysis will always involve some specific valuation assumptions that depend on an investor’s judgment of the security’s risks and liquidity. Essentially, traders try to estimate an unobserved objectively best price for a security. We call this the intrinsic value of the stock. Because of the difficulty of correctly performing this task in real time, all traders and investors will make some errors in their estimations of intrinsic value. While we won’t go into the details, suffice it to say that those who make bigger errors, lose money to those who are better at estimating securities’ correct values.

This pricing mechanism is important because it means there are psychologically driven errors that help or hurt you depending upon when you choose to buy and sell. Over the long run, market participants eliminate pricing errors as more information becomes available. Therefore patience can save you from a loss.

The first point of this analysis is to show that there are two sets of factors determining prices: fundamental “intrinsic” value and the errors in estimating this value that are made by the traders setting prices at any given moment. I think of this second factor as psychological because it relates to the mind and emotions rather than objective factors.

The second point is that the relative importance of these two factors in determining your losses or returns will be linked to the time period you expect to hold a particular investment. In a very important sense, risk is also linked to the time period since the market value of your investment will usually not matter until you must sell it.

In summary, investors often react to emotions - greed and fear. Moods can change rapidly and the result is price changes that cannot be explained by fundamentals such as expected cash flows and interest rates. Over time the market cycles though periods of excessive optimism and pessimism and the returns you earn within a cycle will be strongly influenced by market psychology. Over a long enough period, however, fundamentals determine returns because psychological factors are limited in magnitude and duration. Therefore, if you have a long horizon you need not concern yourself with the volatility of prices that is caused by market mood swings. On the other hand, if you are only investing for a shorter period, these psychological factors may well represent the major part of the risk of your investment.

This view of risk implies that an investment strategy should be tailored to your investment horizon. While a strategy based on fundamentals will provide superior returns in the long run, it may still lose money in the short term and prove inferior to a strategy tailored to the short term psychological "cycle". Of course psychological factors are much harder to predict (at least for me) than fundamentals. Thus, my strategy for short term investing is to stick with investments whose intrinsic value involves fewer assumptions so that they are relatively unaffected by market moods - i.e. fixed income investments tied to short term interest rates.

The above analysis begs the question as to what is meant by long term versus short term. I.e. how long do we need for fundamental factors to outweigh psychological factors. For the record, I have done no formal analysis of this question. My experience tells me that it could take two or possibly three years for fundamentals to outweigh. In "The Little Book that Beats the Market" the author presents statistical evidence that indicates three year horizons are sufficient for a fundamentally based strategy to show superiority.