Chapter 12 of Keynes’s masterpiece The General Theory of Employment, Interest and Money has long been recognised as a brilliant articulation of the tendency towards short-termism in financial markets, containing some of the most widely quoted passages in all of finance and economics. However, the problems that Keynes highlighted have proved stubbornly resistant to change and it is striking that the short-termism he described has, if anything, intensified over the 80 years since his account.
Chapter 12 provides the first clear analysis of the dysfunctionality of capital markets, where Keynes explicitly highlights the social costs of highly liquid financial markets. In many ways, the work undertaken at the Paul Woolley Centre for the Study of Capital Market Dysfunctionality has formalised and extended the ideas first discussed by Keynes in the 1930s. By creating Ricardo Research we hope to build on this work in order to effect change through the behaviour of large asset owners. In this short article, we outline some of the parallels between the ideas contained in Chapter 12 and the research that motivates our work at Ricardo.
The importance of asset prices
Keynes was acutely aware of the role that asset prices play in acting as a signal to corporations and entrepreneurs in the real economy:
“the daily revaluations of the Stock Exchange … inevitably exert a decisive influence on the rate of current investment. For there is no sense in building up a new enterprise at a cost greater than that at which a similar existing enterprise can be purchased; whilst there is an inducement to spend on a new project what may seem like an extravagant sum, if it can be floated off on the Stock Exchange at an immediate profit.”
Keynes asserts here that asset prices play a crucial role in determining whether potentially profitable projects are ignored or wasteful projects are funded. It follows that asset prices are central to the efficient functioning of the economy and if the pricing process is corrupted this can have damaging economic and social consequences. It is therefore essential to look in detail at how asset prices are determined and under what conditions severe asset mispricing might arise.
Long-term investors and game-players
In Chapter 12, Keynes lamented that an increasing proportion of equity was:
“owned by persons who … have no special knowledge of the circumstances, either actual or prospective, of the business in question”.
The problem Keynes is pointing to here is that when an increasing proportion of equity investors have no special knowledge of the businesses in which they invest, there is no reason to expect market prices to be a fair reflection of company fundamentals. Furthermore, we should expect markets to be more volatile than would otherwise be the case, “since there will be no strong roots of conviction to hold it steady”.
He goes on to say that:
“it makes a vast difference to an investment market whether or not they [long-term investors] predominate in their influence over the game-players.”
Keynes’s game-players “are concerned, not with what an investment is really worth to a man who buys it ‘for keeps’, but with what the market will value it at … three months or a year hence.” In other words, they are focused on anticipating short-term market movements rather than assessing long-term value. We believe that the weight of money engaged in momentum and performance-chasing behaviours has created a situation in which “game-players” now almost certainly predominate in their influence over long-term investors, contributing to the dysfunctionality of financial markets.
Keynes also reminds us not to rely on “expert professionals” to help bring prices towards fair value:
“the energies and skill of the professional investor and speculator are mainly occupied otherwise. For most of these persons are, in fact, largely concerned, not with making superior long-term forecasts of the probable yield of an investment over its whole life, but with foreseeing changes in the conventional basis of valuation a short time ahead of the general public.”
The outcome – famously described in Keynes’s beauty contest metaphor – is a situation in which investors focus their efforts on second-guessing each other rather than making independent judgements about long-term value.
Building on his earlier reference to “game-players”, Keynes develops an important distinction between two approaches to investing. The first involves making an assessment of the fair value of a business based on a thoughtful analysis of the company’s long-term cashflow generation prospects – what Keynes calls “enterprise” and we, at Ricardo Research, refer to as “cashflow investing”. The second approach is based on an extrapolation of past price movements – often described as a momentum or trend-following strategy – what Keynes calls “speculation” and which we refer to as “price-only investing”.
In practice, most strategies are a combination of the two approaches (some intentionally, others inadvertently), but we argue that incentive structures create a bias towards price-only behaviours that amplify trends in markets and carry prices away from fair value.
Turning to the plight of the long-term investor, Keynes is at his most pessimistic:
“Investment based on genuine long-term expectation is so difficult today as to be scarcely practicable.”
The situation has not improved since Keynes wrote these words and one shudders to think what he would have made of high frequency trading and trend-following strategies. He continues:
“it is the long-term investor, he who most promotes the public interest, who will in practice come in for most criticism, wherever investment funds are managed by committees or boards or banks.”
Here Keynes presciently highlights the challenge that institutional investors face when adopting a long-horizon approach. The increasingly regulated and litigious environment for fiduciaries has only intensified the risk of criticism (or worse), creating a barrier to the adoption of strategies that run the risk of looking ill-judged in the short run. Keynes adds an insightful footnote relating to performance monitoring processes:
“The practice, usually considered prudent, by which an investment trust or an insurance office frequently calculates not only the income from its investment portfolio but also its capital valuation in the market, may also tend to direct too much attention to short-term fluctuations in the latter.”
Research undertaken at the PW Centre formalises this argument by establishing a clear link between the constraints and incentives faced by asset owners and asset managers, and the momentum and performance-chasing dynamics that result.1 Investors that “direct too much attention to short-term fluctuations” – both asset owners and asset managers focusing on short-term benchmark-relative performance – create destabilising market dynamics and impose a social cost in the form of market crashes and lower returns to the end-saver. Keynes’s widely quoted remark that “it is better for reputation to fail conventionally than to succeed unconventionally” maps neatly to our distinction between short-term performance-chasing (failing conventionally) and long-term cashflow investing (succeeding unconventionally).
Getting back to social purpose
The balance between short-term and long-term investors has a significant influence on the social utility of financial markets. With price-only activities – such as momentum and performance-chasing – now arguably the dominant influence on markets, the resulting mispricing and volatility acts as a costly externality on society. As Keynes put it:
“When the capital development of a country becomes the by-product of a casino, the job is likely to be ill-done.”
Shifting the balance in favour of long-term investors will not be easy, but we are optimistic that by working together, asset owners and the asset management community can foster a healthier and more socially useful financial system. We hope that by directing attention towards the underlying drivers of market dysfunctionality – including misaligned incentives, benchmarking and performance-chasing – we can stimulate a debate that promotes both the private and social interests of the end-saver.