01 August 2009

Time and investment decisions

For those who believe that markets are always efficient and tend to forget the element of time in economics, here is a primer on the biases that arise in investment..short term bias and long term bias and the implications for market pricing.

Also a paper by Bolton et al (RES2006): ‘Executive compensation and Short-termist behaviour in speculative markets’ that shows how the short term perspective can skew investment decisions in the long run.


In times of great heterogeneity in investor beliefs, the optimal incentive contract is designed to partially or completely induce the CEO to pursue the strategy that tends to exacerbate investors’ differences of opinion and to bring about a higher speculative option value. Importantly, both initial shareholders and the CEO can gain from this strategy since it may increase the stock price in the short run. Thus, CEOs may be encouraged to pursue short-term speculative projects even at the expense of long-term fundamental value.

Although short-termist behaviour by managers has been highlighted before (most notably, Stein, 1988, 1989; Shleifer and Vishny, 1990; Von Thadden, 1995), managerial short-termism in these models is not induced by some optimal incentive scheme, but rather due to information or other forms of imperfection, and it arises against the wishes of shareholders. In contrast, the managerial short-termism analysed in our paper is consistent with the speculative motive of incumbent shareholders and therefore would not be eliminated even with active shareholder intervention. More closely related to our paper is that of Froot, Perold and Stein (1992), who provide a discussion of the potential link between the short-term horizon of shareholder and short-term managerial behaviour. They point out that the effective horizon of institutional investors, as measured by the frequency of their share turnover, is about 1 year, much shorter than the necessary period for them to exert long-term discipline on firm managers.

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