Most investors do not have the time horizon they claim to have. Instead, they have the time horizon they reveal through their behavior. In fact, I believe most people have three investment time horizons:
- Stated Time Horizon-What they tell their advisor (or themselves)
- Financial Time Horizon-When they will actually need the money
- Behavioral Time Horizon-How long they can tolerate disappointment before panicking and changing course
The key point is that their behavioral time horizon is generally much shorter than their financial time horizon would indicate. This mismatch is attributable to two primary factors. First, investors experience news and returns continuously-this is particularly true given modern technology which allows us to review our holdings on a daily if not real time basis. Constant feedback and information overload cause people to focus on the short-term even when their goals are long-term in nature. Second, researchers in the field of Behavioral Finance have identified a phenomenon known as Loss Aversion which posits that a financial loss is much more painful than an equal gain is pleasurable. As a result, investors who thought they had a long horizon become overly concerned about short-term fluctuations during difficult markets.
Many will be surprised that the time horizon gap is prevalent even in the case of funds with perpetual time horizons such as endowments and foundations. Even though investment committees are generally populated with sophisticated investors, they are still only human. Moreover, many members are rightfully concerned about the potential for criticism or even legal exposure. Professional investors are exposed to what is known as career risk since their results are generally measured quarterly, and a run of underperformance can be career-ending. So, excessive focus on short-term fluctuations and returns seems almost universal.
The gap between financial and behavioral time horizons is one of the most underappreciated sources of poor outcomes. It can lead to:
- Chronic underweighting of growth assets. As a result of compounding, a lower return makes it much more difficult to accomplish important financial objectives. To demonstrate this point, a 40% stock/60% bond portfolio will likely be worth about 20% less at retirement than one with the reverse weightings!
- Selling at the wrong time. The classic pattern is as follows: investors become more optimistic as the market rises, their risk tolerance increases, allocations to growth/riskier assets increase, the market declines, their time horizon shrinks dramatically, and growth assets are sold. Moreover, most people fail to reinvest until after markets have recovered due to the trauma experienced.
- Constant strategy and manager hopping. Research shows that new managers and/or strategies generally underperform the ones they replaced.
- Stress-Every headline feels threatening. Every market correction feels catastrophic.
The most important time horizon is not the one an investor professes; it is the one that is revealed in times of adversity. When behavioral time horizons are shorter than true financial horizons, portfolios can be subject to a variety of self-inflicted wounds. The gap between the two horizons is a major hidden source of drag on wealth creation. The ultimate investment skill is endurance!