Andrew G Haldane: The short long
Speech by Mr Andrew Haldane, Executive Director, Financial Stability, and Mr Richard
Davies, Economist, Financial Institutions Division, Bank of England, at the 29th Société
Universitaire Européene de Recherches Financières Colloquium, Brussels, 11 May 2011.
* * *
The views are not necessarily those of the Bank of England or the interim Financial Policy Committee. We are
grateful to Nicola Anderson, Sarah Allen, Kath Begley, Antony Ford, Priya Kothari, David Miles, Mette Nielsen,
Peter Richardson, Iain de Weymarn and Laura Wightman for comments and contributions.
1. Introduction
Is the world becoming short-sighted? As individuals, it sometimes feels that way. Information
is streamed in ever greater volumes and at ever rising velocities. Timelines for
decisionmaking appear to have been compressed. Pressures to deliver immediate results seem to
have intensified. Tenure patterns for some of our most important life choices (marriage, jobs,
money) are in secular decline.1 Some have called this the era of "quarterly capitalism".2
These forces may be altering not just the way we act, but also the way we think.
Neurologically, our brains are adapting to increasing volumes and velocities of information by
shortening attention spans. Technological innovation, such as the world wide web, may have
caused a permanent neurological rewiring, as did previous technological revolutions such as
the printing press and typewriter.3 Like a transistor radio, our brains may be permanently
retuning to a shorter wave-length.
If these forces are real, they might be expected to be particularly important in capital
markets. These are a key conduit for choice over time. An efficient capital market transfers
savings today into investment tomorrow and growth the day after. In that way, it boosts
welfare. Short-termism in capital markets could interrupt this transfer. If promised returns the
day after tomorrow fail to induce saving today, there will be no investment tomorrow. If so,
long-term growth and welfare would be the casualty.
Yet, despite its potential importance for long-term growth, studies of short-termism in capital
markets are relatively thin on the ground. There is a sharp disconnect between popular
perception of rising myopia, driven by technology and neurology, and empirical evidence.4
This paper aims to provide some evidence on short-termism drawing on equity market
experience. It is planned as follows.
Section 2 reviews existing evidence on short-termism. Section 3 describes the theory
underlying our test of short-termism and its adverse implications for investment choice.
Section 4 presents the empirical results, drawing on cross-sectional and time-series data.
Section 5 draws out the investment implications of the results and sets out a potential menu
of policy options.
Our evidence suggests short-termism is both statistically and economically significant in
capital markets. It appears also to be rising. In the UK and US, cash-flows 5 years ahead are
discounted at rates more appropriate 8 or more years hence; 10 year ahead cash-flows are
valued as if 16 or more years ahead; and cash-flows more than 30 years ahead are scarcely
valued at all. The long is short. Investment choice, like other life choices, is being re-tuned to
a shorter wave-length. Public policy intervention might be needed to correct this capital
market myopia.
2. The short-termism debate
The short-termism debate is not new. Excess discounting of future outcomes was a familiar
theme among Classical economists. For Jevons, "the untutored savage, like the child, is
wholly occupied with the pleasures and troubles of the moment; the morrow is dimly felt; the
limit of his horizon is but a few days off".5 For Marshall, people acted like "children who pick
the plums out of their pudding to eat them at once".6 For Pigou, it demonstrated a "defective
telescopic faculty" such that "we see future pleasures on a diminished scale".7
And nowhere were these problems more acute than in financial markets. Keynes, himself
part-time speculator, was well-aware of the perils of short-termism in investment choice, both
moral and financial: "It is from time to time the duty of a serious investor to accept the
depreciation of his holdings with equanimity without reproaching himself. Any other policy is
anti-social, destructive of confidence and incompatible with the working of the economic
8
system".
In the US, these sentiments were echoed in the immediate post-war era by Benjamin
Graham, the original "value investor" and yesteryear investment guru to today's investment
guru, Warren Buffett: "A serious investor is not likely to believe that the day-to-day or even
month-to-month fluctuations of the stock market make him richer or poorer".9 And, famously,
"in the short run, the market is a voting machine but in the long run, it is a weighing machine".
Whether an untutored savage, defective telescope or anti-social voting machine, something
sounded amiss.
Thus far, however, this evidence was largely anecdotal. It was not until the 1960s that the
short-termism hypothesis was first tested empirically. This drew on survey evidence from
investing firms. It found that investors typically expected full pay-back on an investment
within 3 to 5 years. At the time, the average life of plant and equipment was often 10 times
that.10 Firms played short even when they desired long.
The first quantitative evidence that discount rates might be high began to appear in the early
1970s. For example, King (1972) examined investment in plant and machinery in the UK.
Empirical estimates suggested the internal discount rate implied by firms' corporate
investment decisions may be up to 25%.11 This literature failed to catch fire. Starting in the
5
Jevons (1871).
6
Marshall (1890).
7
Pigou (1920).
8
Keynes (1938).
9
Graham (1949).
10
Neild (1964) and the National Economic Development Office (1965) used questionnaire-based evidence. A
large proportion of firms in the sample claimed to use a pay-back criterion and of these the modal pay-back
period was 3-5 years. Census evidence from this period indicated that the average useful lifespan of
machines was over 15 years. The distribution of plant and equipment lives in Dean and Irwin (1964) implied a
mean economic life of 34 years.
11
Sumner (1974) reaches similar conclusions.
mid-1970s, it was doused by a torrent of papers testing - and typically failing to reject - the
efficient markets hypothesis.
This new wave swamped empirical finance for the better part of a decade. In the late 1970s
and early 1980s, the efficient markets paradigm appeared all-conquering as a description of
asset price movements in practice.12 Research on the inefficiencies of capital markets
became something of a backwater. The voting machine appeared to be delivering outcomes
both democratic and socially beneficial.
But beginning in the 1980s, a whole sequence of "puzzles" in empirical finance began to
emerge. These were puzzles only in the sense of being deviations from efficient markets. For
Mr Keynes and the Classicists, they would have been anything but.13 For example, an early
set of papers found "excess volatility" in asset prices relative to future dividends and
earnings.14 Investor myopia was one interpretation, with too great a weight on near-term
dividends causing even transitory changes to affect valuation.15
Using an augmented version of this basic asset pricing framework, Miles (1993) tested
formally for excessive discounting of future cash-flows using company-level equity price data
from the UK between 1980 and 1988, finding evidence of short-termism over this period.
Similar approaches applied to longer time-series across a range of countries reached broadly
similar conclusions.16
Yet, latterly, the quantitative evidence appears, as in the mid-1970s, to have dried up. This
time the efficient markets hypothesis cannot be held responsible, for it has come under
increasingly critical scrutiny. Instead we have seen scraps of evidence drawn from the types
of surveys familiar from the 1960s. For example, among asset managers, a 2004 MORI
survey of members of the Investment Managers Association (IMA) and the National
Association of Pension Funds (NAPF) asked if investment mandates created short-termism.
A third of NAPF members and two-thirds of IMA members agreed.
In 2006, a CFA (Chartered Financial Analyst) symposium of financial institutions concluded
"the obsession with short-term results by investors, asset management firms, and corporate
managers collectively leads to the unintended consequences of destroying long-term value,
decreasing market efficiency, reducing investment returns, and impeding efforts to
strengthen corporate governance". Echoes, here, of Graham's anti-social voting machine.
Short-termist behaviour among investors appears to have rubbed-off on companies. Poterba
and Summers (1995) surveyed Chief Executive Officers (CEOs) at Fortune-1000 firms. They
found that the discount rates applied to future cash-flows were around 12%, much higher
than either equity holders' average rate of return or the return on debt. This excessive
discounting implied that some firms were rejecting positive net present value (NPV) projects.
Echoes, here, of Pigou's defective telescope.
Graham, Harvey and Rajgopal (2005) surveyed 401 executives. They found three striking
results. First, managers would reject a positive-NPV project if that lowered earnings below
quarterly consensus expectations. Second, over 75% of the sample would give up economic
value in order to smooth earnings. Third, managers said that this was driven by the desire to
satisfy investors. Echoes, here, of Marshall's plum pudding problem.
Most recently, in 2011 PriceWaterhouseCoopers conducted a survey of FTSE-100 and
250 executives, the majority of which chose a low return option sooner (£250,000 tomorrow)
rather than a high return later (£450,000 in 3 years). This suggested annual discount rates of
over 20%. Recently, Matthew Rose, CEO of Burlington Northern Santa Fe (America's
second biggest rail company), expressed frustration at the focus on quarterly earnings when
locomotives lasted for 20 years and tracks for 30 to 40 years. Echoes, here, of "quarterly
capitalism".
This evidence - anecdotal, survey, quantitative - is broadly consistent with popular
perceptions. Capital market myopia is real. It may be rising. For at least some of the jury,
however, it remains inconclusive. In 2010, Richard Saunders (Chief Executive of the IMA)
summed it up thus: "Now red lights start flashing for me when people talk about
shorttermism, particularly when shareholders feature in the same sentence. What do people mean
when they claim that shareholders behave in a short-term fashion? And what evidence do
they have for it? I have yet to hear a convincing answer to either question".
3. Testing for short-termism
In the quest for some concrete, quantitative evidence, our test of short-termism uses the
forward-looking asset price framework of Miles (1993). A simple example illustrates the basic
approach to testing myopia and its implications for project choice.
(a) A simple example
Consider an investment project costing $60. This investment is riskless and pays $10 at the
end of each of 10 years. The present value of the project is simply the sum of the cash-flows
discounted by the risk-free rate, r:
(1)
With a discount rate of 9%, the project's cash-flows are worth $65 today and its NPV is $5. A
firm or investor offered this project should rationally undertake the investment.
Short-termism implies that agents may discount "excessively" future cash-flows, over and
above the risk-free rate. Denote that short-termism parameter, x. The present value under
myopic discounting then becomes:
(2)
If x is less that unity, then the project's cash-flows are discounted too heavily. For example,
assume x = 0.95 so that one period ahead cash-flows are underestimated by 5%. Even with
this modest degree of myopia, NPV calculations are affected significantly. A $10 return
received at the end of year 5 should be worth $6.65 today. With myopia, it is worth $5.14.
Discounted cash-flows on the project are now worth $52, meaning that the NPV of the
project is negative. A myopic investor would walk away from this NPV-worthy project.
Imagine instead that an investor were making choices based on average payback periods,
rather than NPV. Under rational discounting, the project has a payback period of 9 years.
Under myopic discounting, the payback period rises to 15 years. An investor might now think
twice before investing their money, for their money is committed for almost twice as long.
So short-termism implies that projects with positive returns, or a relatively short payback,
may be misperceived as being negative return or having a relatively lengthy payback. These
projects would fail to receive financing. Investment and, ultimately, growth would be lower
than optimal. In fact, the potential capital misallocation problem is greater still. To see that,
consider the three projects summarised in Table 1.
Table 1
Short-termism and capital planning
Project A B C
Cash-flows (CF) $28 pa in years 6-10 $10 pa every year $16 pa in years 1-5
Cumulative CF $140 $100 $80
NPV (rational) $73 $66 $63
Ranking (rational) 1 2 3
NPV (myopia) $49 $52 $55
Ranking (myopia) 3 2 1
In the absence of short-termism, project A is selected. Its payouts are back-loaded but
significant; it generates a net excess return of 22%.17 Short-termism hits such long duration
projects hardest. The impatient investor chooses project C. This project delivers lower
cashflows but these are front-loaded. In NPV terms, the project selected is the worst on offer,
whereas the rationally optimal project ranks last. Capital allocation is not just sub-optimally
low; it is also skewed towards sub-optimally short-duration projects.
(b) Asset pricing
Consider now a formal model of multi-period equity price determination. Finance theory
typically assumes that investors care about both the level and uncertainty of their wealth and
are risk averse. In this world, agents require a premium to invest in a company. More
formally, the expected return can be written as the sum of the risk free rate and a
companyspecific risk premium for company j:18
(3)
The actual return on an investment is the sum of the capital gain and the dividend yield:
(4)
Assuming an efficient market, actual returns differ only from expected returns due to a
forecast error which is uncorrelated with expected returns.19 Using this assumption, we can
substitute (4) into (3) to give an equation for the equity price.
So the price of the security is simply the expected price and dividend in the next period,
discounted by the sum of the risk-free rate and the company-specific risk premium.
By repeated substitution, this asset pricing equation can be written as a generalised form
of (1):
(6)
The current share price is a function of future discounted dividend streams and a discounted
terminal share price, where we have used:
(7)
(8)
Equation (7) says that the expected company-specific risk premium is constant and
pre-determined based on period t information. Equation (8) says that expectations of future
risk-free rates are defined by the path of the risk-free forward rate curve observed at time t.
Equation (6) can be modified with a myopia coefficient to give a generalised version of (2):
(9)
The null hypothesis - no short-termism - implies x = 1. Drawing on evidence across time and
industrial sectors, it is this restriction we now test.
4. Testing for short-termism
The data comprises a panel of 624 firms listed on the UK FTSE and US S&P indices over the
period 1980-2009.20 These span a broad range of industrial sectors, as shown in Table 2.
Table 2
Number of firm level observations in each industry segment
Energy
Index Consumer & Financials Health IT Industrials Materials Total
Utilities
S&P 117 65 78 47 73 47 23 450
FTSE 52 14 42 5 34 18 9 174
The core inputs to the analysis are firm-level measures of dividends and equity prices. The
average dividend-price ratio in each industry segment is shown in Table 3. The mean
dividend-price ratio across the panel is 2.6%. But there is a fairly significant degree of
crosssectoral and time-series dispersion. For example, dividend-price ratios are almost twice as
high in the energy and utilities sector as the health and pharmaceuticals sector. And mean
dividend-price ratios were two thirds third higher in the 1990s compared to the 1980s.
Table 3
Mean dividend-price ratio for firms in each industry segment
Energy &
Consumer Financials Health IT Industrials Materials
Utilities
S&P 1.94 2.82 3.19 1.87 1.69 2.55 2.22
FTSE 4.12 3.96 2.63 1.38 2.92 3.81 3.16
To estimate (9), we require a selection of quantitative inputs. Taking these in turn:
(a) Company-specific risk premium
Following Miles (1993), the company risk premium is modelled based on firm-specific
characteristics, in particular the company beta and the level of gearing:
(10)
where .21 Betas are estimated using daily return data for firms listed on the S&P 500
and FTSE, together with daily data for the indices themselves.22 Mean estimated betas are
shown in Table 4. These average below one for both UK and US firms. As Charts 1 and 2
illustrate, however, the distribution of betas is fairly wide, with over a third of US firms and
almost a fifth of UK firms having a beta in excess of unity.
Table 4
Estimated betas
Number of Number of
Mean Median S.D
Index
firms observations
S&P 401 10,140 0.91 0.86 0.49
FTSE 168 3,765 0.63 0.62 0.45
Chart 1 Chart 2
Distribution of betas - US Distribution of betas - UK
Sources: Thomson Reuters Datastream and Bank Sources: Thomson Reuters Datastream and Bank
calculations. calculations.
Notes: Shows estimated betas for the US firms. The chart Notes: As for Chart 1 but for UK firms.
is drawn for betas lying between -1 and 3 with 400 bins.
The second component of the firm-specific discount factor is company gearing. This was
constructed using annual Thomson Reuters Datastream data for book value per share, the
number of shares outstanding and debt outstanding. Other things equal, higher gearing
would suggest a higher company-specific discount factor.23 The final element in the firm-level
discount factor calculation is the risk-free rate. The yield on government securities was used,
based on data from the Federal Reserve and Bank of England.
Having estimated (10) using pooled US and UK regressions over 20 years, a firm-specific
risk premium can be calculated. The average premium across the sample is 5.9%. As
Chart 3 shows, both gearing and beta contribute to the company risk premium estimates.
Chart 3
Estimates of company risk premium
Sources: Thomson Reuters Datastream and Bank
calculations.
Notes: Uses the estimated coefficients from the pooled UK
and US regression together with the mean annual values of
beta and gearing for firms in the US and UK.
(b) Expected dividends and prices
The right-hand-side of equation (9) defines the stream of future dividends and terminal
prices. To generate these, consider a simplified version of (9) which abstracts from discount
rates, company-specific risk premia and dividends:
(11)
Following Wickens (1982), the rational expectation t+N periods ahead are formed on the
basis of information available at time t. For each company j, these expectations differ from
the realised values by a forecast error ( ) unpredictable at time t:
(12)
Adding and subtracting the average forecast error across all companies ( ) gives:
(13)
Actual prices cannot be used in the estimation of (13) as these are not known at time t and
are correlated with the error term ( . But consistent estimation of
(13) is possible using a set of instruments correlated with but which are independent of
the company-specific excess forecasting errors. In the estimation, lagged share prices,
lagged dividends per share and lagged earnings per share are used as instruments for future
dividends and equity prices. These are known at time t but are uncorrelated with the error
term. Five lags of each variable (price, dividends, earnings) are used as instruments.
(c) Generating estimates of short-termism
Given estimates of company beta and gearing, risk-free rates and the instrumented
variables, equation (9) can be estimated to generate estimates of the short-termism
parameter, x. This was achieved using non-linear least squares on a set of cross-sectional
regressions for each of the years 1985 to 2004.24
Chart 4 shows point estimates of x for each of these years. Short-termism estimates which
are statistically significantly below unity (at the 5% confidence level) are shown in red. The
simple average of x across the 20-year period is very close to one (0.9935). On the face of it,
this does not suggest that short-termism has been a particular problem among this
crosssection of firms.
Chart 4 Chart 5
Short termism estimates over time Industry estimates
Source: Bank of England. Source: Bank of England.
Notes: Bars show the estimated x parameter for Notes: Bars show the industry estimates for the
regressions for the UK and US pooled data. sample split into (1) 1985-1994, and (2) 1995-2004
Estimates where the 95% confidence interval spans 1 for each industry. S&P and FTSE industry
are coloured grey. classifications were used. Bars are coloured based on
the significance of the estimates at the 5% level.
But this masks some important within-period variation. In 13 of the 20 years, x is lower than 1.
And in 9 of these years, x is statistically significantly below unity. Moreover, there is evidence of
a rising tide of myopia: 8 of these 9 years occur in the final decade of the sample.
To illustrate, Table 5 shows point estimates of x over two decadal sub-samples (1985-1994 and
1995-2004) and over the full sample. Estimates are significantly below unity in the second
sub-sample, but not the first. The point estimate of x over the second sub-sample is 0.94.25
Table 5
Short-termism estimates for the US and UK
Year x Standard error Evidence of short-termism?
Full sample (1985-2004) 0.937 (0.004) Yes
1985-1994 1.001 (0.008) No
1995-2004 0.938 (0.005) Yes
Notes: The significance column refers to a test of x<1 at the 5% confidence level.
Table 6 shows estimates of x over the same three samples on a sectoral basis. It echoes the
message from Table 5. There is statistically significant evidence of short-termism in the
second half of the sample for all seven industrial sectors. And in all of these sectors except
health and materials, x is lower in the second half of the sample than the first - in those two
sectors x is below unity throughout the sample.
Although short-termism appears to be a consistent theme across industrial sectors, there are
nonetheless some interesting patterns in the degree of short-termism across sectors. For
example, the financial sector does not appear especially short-termist over the full sample.
By contrast, the health and materials sectors exhibit short-termism throughout.
Table 6
Sectoral short-termism estimates for the US and UK
Full Sample
1985-1994 1995-2004
1985-2004
Industry x Significant? x Significant? x Significant?
Consumer 0.939 Yes 1.007 No 0.94 Yes
Energy and Utilities 0.939 Yes 1.05 No 0.934 Yes
Financials 0.965 Yes 1.087 No 0.963 Yes
Health 0.940 Yes 0.857 No 0.940 Yes
IT 0.902 Yes 0.957 No 0.892 Yes
Industrials 0.926 Yes 1.018 No 0.925 Yes
Materials 0.875 Yes 0.871 Yes 0.874 Yes
Notes: The significance columns refer to a test of x<1 at the 5% confidence level.
5. Short-termism and public policy
These tests of short-termism point to two key conclusions. First, there is statistically
significant evidence of short-termism in the pricing of companies' equities. This is true across
all industrial sectors. Moreover, there is evidence of short-termism having increased over the
recent past. Myopia is mounting.
Second, estimates of short-termism are economically as well as statistically significant.
Empirical evidence points to excess discounting of between 5% and 10% per year. To
illustrate the impact of this on investment choice, consider the earlier project with an annual
income stream of $10.
Chart 6 shows the present value of those income streams under three counter-factual
assumptions: rational discounting; myopic discounting - lower bound (5%); and myopic
discounting - upper bound (10%). The cumulative impact is fairly dramatic. Ten-year ahead
cash-flows under rational discounting are valued similarly to between six-year (lower bound)
and four-year (upper bound) ahead cash-flows under myopic discounting. The long is
shortened.
Chart 6 Chart 7
Present value of future cash-flows Cumulative present value of future
cash-flows
Notes: The chart assumes $10 is paid at the end of Notes: The cumulative NPV of $10 cash-flows rises to
each year. The rational discount rate used is $61 in year 9 under rational discounting. With mild
1.085. myopia (x=0.95) it only passes $60 at year 15. With
severe myopia (x=0.90) the investor calculates that
payback is not achieved.
Table 7
Point in future at which residual discounted cash-flow falls below (years)
10% 1% 0.1
Rational (x =1) 29 57 85
Mild myopia (x = 0.95) 18 35 52
Strong myopia (x = 0.90) 13 25 37
Notes: The number in the table refers to the first year that a $10 cash-flow falls below 10%, 1% and 0.1% of its
actual value in present value terms. The rational discount uses an average risk free rate from our cross sectional
data sample (1.085).
This is illustrated even more clearly if we consider payback periods. Under rational
discounting, payback occurs in 9 years (Chart 7). Under upper bound myopic discounting,
the investor today would erroneously assume that payback would never be made. These
differences have the potential to alter radically project choice. The net present value of this
project evaluated over 50 years falls from $56 under rational discounting to a loss of
$11 under extreme myopia. In other words, a NPV-positive project would be resoundingly
rejected.
To put the point more starkly, Table 7 asks at what point in the future the residual value of a
future cash-flow hits a level of 10%, 1% and 0.1% of its face value, under rational and
myopic discounting. Under rational discounting, cash-flows even 50 years ahead retain more
than 1% of their face value. Under strong myopic discounting, this residual threshold is
reached after 25 years. Virtually zero weight - less than 1000th of the face value of the
cashflow - is placed on projects with income streams much beyond 35 years. The long is
dramatically shortened.
This is a market failure. It would tend to result in investment being too low and in
longduration projects suffering disproportionately. This might include projects with high build or
sunk costs, including infrastructure and high-tech investments. These projects are often felt
to yield the highest long-term (private and social) returns and hence offer the biggest boost to
future growth. That makes short-termism a public policy issue.
But what would be an appropriate public policy response to this capital market failure? A
number of proposals have been suggested by various authors. These include:
(a) The lightest touch approach would be to require greater disclosures
Transparency:
by financial and non-financial firms of their long-term intentions - for example, their
long-term performance, strategy and compensation practices.26 For financial firms,
this might include metrics of portfolio churn. This could be accompanied by a
programme of educating managers, investors and advisors of their fiduciary
responsibilities.
(b) Governance: A more intensive approach would involve acting directly on
shareholder incentives through their voting rights. For example, fiduciary duties
could be expanded to recognise explicitly long-term objectives.27 More concretely,
shareholder rights could be enhanced for long-term investors, perhaps with a
duration-dependent sliding scale of voting rights.28
(c) Contract Design: There have been various attempts over the past few years to
make compensation contracts more sensitive to long-term performance and risk.
This includes employment contracts conditioned on long-term performance, or with
deferral or clawback. Changes in the compensation instrument can also help - for
example, remunerating in equity is better than in cash and remunerating in junior or
convertible debt might be better than either.29
(d) Authors have suggested a variety of ways in which
Taxation/Subsidies:
government could penalise short-duration holdings of securities, or incentivise
longduration holdings, using tax and / or subsidy measures. These measures differ in
detail, but the underlying principle is to link them to the duration of an investor's
holdings or the length or nature of a company's investment.30
Some of these initiatives have been tried and tested in differing degrees, at different times
and in different countries. They have not obviously arrested the short-termism trend. It might
be time to increase the level of policy ambition if the telescope is to be corrected, the voting
machine socialised, the savage civilised. Public policy could help keep the plums in the
pudding. Without intervention, the long could become shorter still.
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