How To Make Money In Stocks Part 2: The Time Horizon Premium 2 comments

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There are several premiums that can be reaped which appeal to the investor. A key one among these is the time horizon premium.

This is nothing new in the investment world. Those willing to put their money in fixed deposits with long maturities can get better rates than for say, checking accounts. For bonds, typically the yield (interest rate) rises with increasing time maturity. The difference in yields between long and short-term instruments is to compensate investors for having their money committed for longer periods.

There are risks with having excessively long-term horizons. One of these is opportunity cost of better alternative investments. The second is liquidity mismanagement. Some might have become familiar with the structured investment vehicles, or SIVs, that have run into problems recently. These SIVs typically borrow short-term money to invest in long-term bonds and other instruments to take advantage of the higher yields. Now they find that it is difficult to roll over their short-term debt, and hence face the prospect of having to dispose of their long-term investments at firesale prices.

But really, for the individual retail investor like you and me, the need for short-term cashflow circulation should not be an issue as long as we do not incur big obligations (eg. oversized housing loans, margin debt). As long as we do not foresee any need to sell off our stocks at short notice to finance something, what is there to stop us from having a longer investment horizon, or holding period?

Note that this does not equate to a slavish adherence to the "buy-and-hold" philosophy. It does not mean that one can just sleep on his stock over a long period and expect to reap the "patience premium". To do so might entail frustration if the individual fails to monitor the company closely and it subsequently falters. Reaping the time horizon premium is not about laziness.

Rather, it is about an intelligent bet where one sets out deliberately to capture the time horizon premium at the expense of shorter-horizon players who are constrained by the need for short-term liquidity. I have often wondered why risk is defined as price volatility. Surely, day-to-day up-down swings should not be that important for the long-term player, as has been pointed out by Warren Buffett himself. And indeed, it is not important ...... except for the many institutions that need to manage asset-liability risk exposure and therefore cannot afford to see their asset prices swing violently to the point of defying prediction and "risking" the danger of they being forced to sell at the worst point (the price trough) to meet their short-term liability funding needs. These institutions include banks, hedge funds, the abovementioned SIVs and other structured vehicles, and even some pension funds, insurance companies and unit trusts (to meet redemptions). The concept of risk is defined for them, and it is not that relevant for the investor with a long-term horizon (read my article on risk). It is my belief that there really needs to be an alternative definition, but meanwhile let's just profit from it.

As long as one understands the long-term value in a company, then market swings which force short horizon-holders to sell good and bad stocks alike will produce the best opportunities for reaping this time horizon premium. In this kind of situations, the investor should be patient in holding, since he can afford to do so without need for immediate return. This, I believe, is essentially what Buffett means by "buy-and-hold" and his Mr Market analogies. The key thing to note about this strategy is that unlike bonds or fixed-deposits, there are no clear contractual promises about reaping this time premium: that is why it is important to monitor the investment consistently.