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Behavioural finance: short termism

January 2016

At the start of a new year, investors tend to ponder the prospects for the subsequent 12 months. It says something of how short term the focus in markets has become that this may be one of the relatively few occasions when many investors even think that far ahead. Such short termism, however, is at odds with building long-term portfolio wealth.

But it turns out that investors are hard-wired for short termism. In experiments, investors routinely value short-term gains more than they value delayed benefits. The culprit here is dopamine, a feel-good chemical that our brains release when faced with a short-term reward. In fact, the possibility of imminent monetary reward has been shown to trigger dopamine release in much the same way as food and alcohol can.

Neuroscientists have shown that different parts of the brain are responsible for valuing short- and long-term monetary payoffs.  Behavioural studies show most people would take $100 today over $200 in a year's time, but would not take $100 in six years over $200 in seven. There is no rational reason for this inconsistency; the trade-offs are identical in monetary terms.

The problem of short termism in stock markets runs deeper than just investors. It is part and parcel of how stock markets function due to the way in which future company earnings are valued by the investment industry. The issue here is that most sell-side analysts focus heavily on short-term earnings projections over the next one to three years.

So, how should investors go about beating the market? One approach is simply to take a longer view than the majority. Given the greater short-term focus of investors and sell-side analysts, the equity market has become relatively effective at pricing near-term earnings expectations where there tends to be greater certainty. However, the market is less effective at evaluating longer-term earnings, showing a relative neglect for the longer-term value of companies exposed to strong structural growth. This represents an opportunity for investors and investment strategies that can sensibly identify structural growth winners.

Exposure to structural growth allows a company to generate a steady stream of cash that can be reinvested into a growing business. It is the ability of these companies to reinvest that cash into the strong growth opportunities that provides the compounding engine for sustained, long-term growth in their earnings. And, this is where an understanding of longer-term drivers and trends such as demographics can be particularly useful in informing the investment process.

Short termism may be rife in equity markets, but the evidence suggests investors can use this to their advantage by taking a long-term view and investing in those strategies that are designed to do likewise.

This document is issued by FIL Responsible Entity (Australia) Limited ABN 33 148 059 009, AFSL No. 409340 ("Fidelity Australia"). Fidelity Australia is a member of the FIL Limited group of companies commonly known as Fidelity International.

Prior to making an investment decision, retail investors should seek advice from their financial adviser. Please remember past performance is not a guide to the future. Investors should also obtain and consider the Product Disclosure Statements ("PDS") for the fund mentioned in this document. The PDS is available on www.fidelity.com.au or can be obtained by contacting Fidelity Australia on 1800 119 270. This document has been prepared without taking into account your objectives, financial situation or needs. You should consider such matters before acting on the information contained in this document. This document may include general commentary on market activity, industry or sector trends or other broad based economic or political conditions which should not be construed as investment advice. Information stated herein about specific securities is subject to change. Any reference to specific securities should not be construed as a recommendation to buy, sell or hold these securities. While the information contained in this document has been prepared with reasonable care, no responsibility or liability is accepted for any errors or omissions or misstatements however caused. The document may not be reproduced or transmitted without prior written permission of Fidelity Australia The issuer of Fidelity managed investment schemes is FIL Responsible Entity (Australia) Limited ABN 33 148 059 009.

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This information is of a general nature only and has been provided without taking account of your objectives, financial situation or needs. Because of this, you should consider whether the information is appropriate in light of your particular objectives, financial situation and needs.