Imagine you are offered a bet on the outcome of the repeated flip of a coin. You can choose whether this is over 10, 100 or a 1,000 flips. Everyone thinks that a fair coin is being played, but you know that it is slightly weighted in favour of coming up heads. Which version of the game would you want to play? 1,000 flips, of course. If the probabilities are on your side then you want to extend the sample as much as possible – this gives the best chance of dampening the noise and letting the true odds come to pass. It is the same for investors – it is not enough to have an edge, you need to have the time for it to play out. That is a luxury that very few hold.

Blunting Edges

Unfortunately, life is a lot more difficult for investors than the coin flip example suggests. We never really know whether we have an edge (we just all think we do) and, if we are attempting to be a long-term investor, we may only make a handful of genuinely consequential decisions in our lifetime. The critical point is, however, if we believe that we have an investment approach where the probabilities are on our side then we have to give it time to work.

Having an investment strategy with an edge, and marrying that with a too short time horizon is identical to possessing no advantage at all. We are just entirely beholden to randomness. It is not enough for us to believe that the probabilities are in our favour, we must also be confident that we can persist with it so that we can benefit from those odds. If we cannot, then we shouldn’t be doing it.

For most investors, whether we have an edge or not is irrelevant because our time horizons (chosen or enforced) are too short for it to matter even if we did.

Disappointment and Disaster

If a good strategy benefits from a larger or longer sample then the opposite is also true. A bad investment process – one where the odds of success are against us – suffers from an extended horizon.

The worse our investment approach the more brevity is an advantage. We don’t want to wait to find the true odds, we want to be lucky.

If we have a sub-optimal strategy, the longer our horizon the more likely it is that we will encounter its disappointing reality. There is, however, something more pernicious than this slow trudge toward underwhelming returns, and that is an approach with the propensity for disastrous losses.

When there is the potential for catastrophe embedded within an investment process – most typically because they have leverage, concentration or both – time becomes our enemy. It is not just the odds that matter here, but the range of outcomes. Think of it like home insurance. If we decide not to renew our policy we make an immediate profit (or at least save on a cost), but expose ourselves to an incredibly unpleasant tail risk. A risk that increases with time. One day without insurance is a vastly different proposition to ten years.*

Asymmetric Agents

If an investment strategy has no edge, or carries the potential for severe and sharp losses, is it always better to have a shorter horizon? Not always. It depends on who actually bears the downside risk.

If there is a situation where an investor can benefit from the upside but other people suffer the losses then they will be incentivised to run even a poor strategy for as long as possible. The asymmetry is firmly on their side. They benefit from the luck and randomness that might result in positive outcomes, and are happily insulated from sharply deleterious outcomes.

This might seem like an unrealistic hypothetical but it is not. Imagine a hedge fund strategy capturing performance fees on an annual basis with no or partial claw back (not something that needs much imagination). They hold a free, or at least low cost, option on striking lucky, and they have no interest in that option expiring.

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Investors spend a lot of time thinking about edges, but not a great deal of time thinking about what is required to benefit from them. For most it is not getting the odds on our side that is the difficult thing, it is playing the game long enough so that they matter.

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* This relates to the importance of ergodicity in investment decision making – which you can read more about here.

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My first book has been published. The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can get a copy here (UK) or here (US).