Time Arbitrage

Time Arbitrage

Investment is a process in time

Hyman Minsky

There is a short term bias that exists in the world of the stock market. Over time the fast pace of modern society has overtaken everything in our culture including the way we view investing in the financial markets. Everybody wants to make money faster especially when the market is going up and it goes up most of the time. 

The investment industry has morphed over the years into more of a marketing business that is based on satisfying the short term gratification of it's participants. Mutual funds are set up to satisfy what the investing public wants and what they want is short term performance. How the fund performed over the last quarter. There is a recency bias that exists in investing where people are overly affected by what happened last month, last week and even yesterday. In response to this mutual fund managers are constantly judged by their recent performance. Fund inflows and outflows are driven by how they rank against their peers in the last quarter. Faulty incentives are perpetuated rewarding the fund manager for maximizing fund inflows and negating fund outflows. Fund managers end up making decisions based on short term performance while sacrificing long term strategy. It's even worse in the hedge fund world where they are expected to show positive results every month.

And of course the media play their part hyping last years top mutual fund performers with fancy charts and splashy advertising. But in the end the media are only fulfilling the the public's need for instant gratification.

The result of all this is the funneling of money into stocks that are doing well right now. This can affect the way the management of these companies run their businesses with an emphasis on pumping up earnings so they can make their numbers when the next quarter is reported. 

All of this creates a situation that you can refer to as time arbitrage but its really about Wager Value again. If an investor can focus on the longer time term and ignore short term performance in his stock holdings he can fade what the majority of the investing world is doing and make more money in the long run by exploiting these inherent market inefficiencies.

A good example of time arbitrage is when a good company (high returns on invested capital over the years) misses their quarterly earnings number. The market will clobber the stock presenting the astute investor with an opportunity to get into a good investment at a discount. In other words the stock will go on sale for awhile. But the investing public caught up in short term performance will dump the stock instead of buying it. It's the emotion of the market place again and it happens every quarter, all you have to do is wait for it.

In other words, be contrary during market extremes. I know I've repeated that line again and again but its one of the great truths in investing.