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Two Biggest Mistakes of Long-term Investors

November 18, 2011 • Posted in Big Ideas, Strategic Allocation

How can long-term investors maximize their edge of strategic patience? In their November 2011 paper entitled “Investing for the Long Run”, Andrew Ang and Knut Kjaer offer advice on successful long-term investing (such as by pension funds).  They define a long-term investor as one having no material short-term liabilities or liquidity demands. Using the California Public Employee’s Retirement System and other large institutions as examples, they conclude that:

  • Long-term investors can:
    • Ride out short-term fluctuations in returns.
    • Exploit instances of short-term mispricing.
    • Exploit high-premium illiquidity. 
  • The two biggest mistakes of long-term investors are:
    1. Procyclical tactical reallocation (shifting portfolio weights in the same direction as relative past performance instead of rebalancing to fixed weights or reallocating in a contrarian manner).
    2. Accepting investment manager/advisor goals (short-term performance fees) in conflict with a long horizon and “fake skills” that obscure risk.
  • Long‐horizon investors should:
    • Be rigorously contrarian by strict rebalancing to fixed portfolio weights, or more  aggressively, to weights dynamically set by robust valuation‐based rules.
    • Focus on diversification across socioeconomic factors (such as inflation, economic growth and political risk) and investment factors (such as value‐growth and momentum) rather than asset classes.
    • Upgrade their own investment competence (understanding risk and reward) to support incentivizing, monitoring and evaluating investment managers/advisors.
    • Demand elevated returns for illiquid investments as compensation for associated constraints on rebalancing.

In summary, evidence from institutional experience suggests that long-term investors should be contrarian, diversified across factors (anomalies) more than asset classes and knowledgeable enough to set long-horizon incentives for investment managers/advisors.

Though presented in institutional context, the advice likely applies to individual investing and smaller-scale investment managers.

Cautions regarding conclusions include:

  • Reported evidence is weakly quantitative. It is difficult to analyze long-run investing quantitatively because samples are always short relative to investment horizon.
  • To the extent the market is adaptive, returns of widely known factors diminish over the long run.
  • To the extent that researchers snoop, out-of-sample factor returns are lower than those implied by simple historical analysis.
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