Friday, October 21, 2011

Short-Termism, Patience and Finance

As a popular open-source encyclopedia states, time preference pertains to how large a premium a consumer places on enjoyment nearer in time over more remote enjoyment. Some readers may be more used to thinking of this as "patience"; which the same open-source encyclopedia tells us is "the state of endurance under difficult circumstances, which can mean persevering in the face of delay or provocation without acting on annoyance/anger in a negative way; or exhibiting forbearance when under strain, especially when faced with longer-term difficulties." So there is an obvious overlap between these concepts: illustrated well by the Stanford Marshmallow Experiment.

I have elaborated on the above because I recently read a paper on time preference in the domain of finance, with the following title: "Patience and Finance". This was essentially a speech delivered last year by Andrew Haldane, the Executive Director for Financial Stability at the Bank of England. I became aware of the paper after doing a key-word search for "patience" -- and then discovering a link to Haldane's speech on the Corporate Law and Governance blog. That blog-post also describes a lecture delivered by Haldane in May of this year, as follows:
"In the lecture - titled "The short long" and available here (pdf) - Mr Haldane notes the (relative) paucity of studies on short-termism in capital markets. He argues, on the basis of his empirical research, that short-termism is statistically and economically significant in capital markets and appears to be increasing. In response to this finding of market failure, Mr Haldane identifies possible public policy responses including those concerning transparency, governance, contract design and taxation."
I googled "short-termism" to find more material on the problem; and found this Telegraph artcle from last year: "Vince Cable was right on the evil of short-termism". The Telegraph article states that: "humans are seemingly hard-wired for short-termism and, worse, they make poorer decisions the more short-term they become. Ask someone if they prefer £10 in a year or £11 in a year and a day and they will, rightly, opt for the £11. But ask them if they would prefer £10 today or £11 tomorrow and they will invariably put out their hand for the money straight away." This is of course, the classic hyperbolic discounting example.

The Telegraph article also tackles the question of why the financial services industry has become fixated on short-term performance: "Companies which used to announce figures twice a year now feel the need to do so quarterly. Fund managers are judged on ever-shorter timescales and unsurprisingly start to play it safe, hugging benchmarks and avoiding the long-term judgements that may be right but won't necessarily come good before the next review. As Keynes observed way back in 1936: 'Investment based on genuine long-term expectation is so difficult today as to be scarcely practicable'."

Of course, the recent speech (and lecture) by Andrew Haldane indicates that the quote from Keynes rings true very much today. Even though there has been talk about long-term incentive plans and "long-term bonuses" for the financial sector, it remains unclear to me if anything substantial is being done to reduce the extent of short-termism in finance. However, there is laboratory evidence on the benefits of improving incentive structures, produced 20 years ago at this stage: "Behavioral Consequences of Corporate Incentives and Long-Term Bonuses: An Experimental Study". There is even a recent book with chapters on 'Investment Management Short-Termism' and 'Long-Term Performance Incentives for Investment Managers': "Saving Capitalism From Short-Termism: How to Build Long-Term Value and Take Back Our Financial Future".

To finish, I will ask if any reader has ever heard of the term IBGYBG? Apparently it is "a text-messaging acronym, like LOL or OMG. It was shorthand for a phrase often used in the investment banking business during the run-up to the 2008 Great Financial Crisis". It meant: "I’ll be gone; you’ll be gone". Now that is all about the short-term.


Kevin Denny said...

Discussions about short-termism, at least in the public domain, tend to be quite normative. Implicitly the assumption is that short termism is a bad thing. The Telegraph article more or less says that. But if short termism is just a particular set of preferences, whats not to like? If I choose to live for today because thats what I'm into well thats my business.
But I suspect that there may also be a notion that short-termism represents some sort of cognitive bias in which case people are not acting in their own interests.
So at the very least one needs a clear definition of what it means and why it is a problem.

Martin Ryan said...

Thanks for the feedback Kevin. I must say that I thought the headline of the Telegraph article ("the evil of short-termism") was over-the-top. I take your point seriously too: especially in relation to the preferences of any one individual.

However, I am not thinking along the lines of individual behaviour that reduces the welfare of said individual. I know there is a whole body of work on whether "people know what is best for them":

# Gruber, Jonathan H. and Mullainathan, Sendhil (2005) "Do Cigarette Taxes Make Smokers Happier," Advances in Economic Analysis & Policy: Vol. 5: Iss. 1, Article 4.

# B. Douglas Bernheim & Antonio Rangel, 2009. "Beyond Revealed Preference: Choice-Theoretic Foundations for Behavioral Welfare Economics," The Quarterly Journal of Economics, MIT Press, vol. 124(1), pages 51-104, February.

# B. Douglas Bernheim, 2009. "Behavioral Welfare Economics," Journal of the European Economic Association, MIT Press, vol. 7(2-3), pages 267-319, 04-05.

However, I am thinking more along the lines that *aggregate short-termism* contributes to instability in the business cycle; and therefore that it must be addressed with initiatives such as long-term reward structures.

A simple example is the mortgage salesman who sells as many mortgages as he can -- because all he is concerned with is making commission in the short-term. What if he sells mortgages to people who can't really afford them though? And what if everyone in his industry does the same?