It is important to think carefully about our investment philosophy – defining what we believe about investing is critical to good decision making. Even if we adopt a sound philosophy, however, it will not do us much good unless it is consistent with our time horizon. A mismatch between our philosophy and the time over which we execute it will almost inevitably lead to bad outcomes. 

In a recent paper on how investors develop asset class return expectations AQR’s Antti Ilmanen made the point that the success of different approaches depended on our time horizon. Of particular note, was this distinction:

– Valuation / Yield: 3 to 10 years. *

– Momentum: Less than a year
 
Over short-run horizons investors tend to extrapolate, performance tends to persist, and we see a momentum effect. The valuation or fundamental attributes of an asset don’t matter that much. If we want to estimate returns over the next year, looking at what worked last year might just be our best bet.

Over the longer-run, however, the value of an asset both in terms of cash flows received and potential for reversion to the mean starts to exert far more influence.

Where investors go consistently wrong is applying their philosophy to an unsuitable horizon. For an investor who cares about valuations, a one-year view is close to pointless. Value just does not have much predictive power over such a short period.**

Likewise, a momentum investor operating on a 5-year horizon is acutely vulnerable to valuation mean reversion. As Cliff Asness notes: “It is sadly common for investors to act like momentum investors at reversal horizons”.

The classic example of this destructive behaviour comes in the active fund industry.

The vast majority of investors in this space are momentum-driven (they might not admit it, but they are). The problem is that they apply a momentum or performance chasing strategy to an ill-fitting horizon. They define what is good or bad based on 3/5 year performance – a quasi-momentum approach over a duration where valuation becomes critical. The entire industry is complicit in this behaviour – private fund investors, professional investors, asset managers, platforms and regulators.

This is exactly why star fund managers emerge and crash, why money floods into top performers and laggards close, why fund buy lists are a carousel of in-vogue styles and why flavour of the month themes almost always fail to deliver. Everyone is (secretly) chasing momentum over horizons where mean reversion risk is severe and fundamentals start to win out.

A significant amount of active fund manager due diligence is carried out to justify 3/5 year momentum trades.

There is nothing wrong with a momentum approach, but it is important to admit it, be disciplined in executing it and to adopt the correct time horizon. If we can’t even acknowledge we are doing it, we probably won’t be doing it very well.

The additional challenge we face is not knowing what our real time horizon is. It will inevitably be shorter than we believe it to be.

Our genuine horizon is not what we think or say it is, but the time period over which we are incentivised or compelled to act. If our stated horizon is 5 years but we are under pressure after 1 year, that’s our horizon, whether we like it or not. Investors who have control over their time horizon have a profound advantage over those that don’t.

Before deciding on our investment philosophy, it pays to ask how much time we have. 

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* What about longer than ten years? Over the very long-run the impact of momentum and valuation reversals are likely to be overwhelmed by the steady compounding of earnings / cash flows and this will dominate equity returns. (Unless valuations are very extreme). 

** In many cases adopting a value-orientated approach will reduce the likelihood of success over the next 12 months, on the basis that we could well be reducing our exposure to momentum. Not many people are willing to trade-off worse short-term results for the better long-term results.

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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).