Why is it that the community of long-term investors, such as public pensions and sovereigns, can’t seem to extend their time horizon beyond 3-4 years? For a unique answer, I’d like to turn to comedian Jerry Seinfeld, as he has a rather astute observation that may help us understand how inter-generational funds get bogged down in annual and even quarterly returns:
“I never get enough sleep. I stay up late at night, because I’m Night Guy. Night Guy wants to stay up late. ‘What about getting up after five hours sleep?’ Oh, that’s Morning Guy’s problem. That’s not my problem, I’m Night Guy. I stay up as late as I want.
So you get up in the morning, you’re exhausted, groggy…‘Oooh I hate that Night Guy!’ See, Night Guy always screws Morning Guy. There’s nothing Morning Guy can do. The only thing Morning Guy can do is try and oversleep often enough so that Day Guy looses his job and Night Guy has no money to go out anymore.”
It’s a hilarious bit because we’ve all been there; it’s human nature to let the ‘Night Guy’ in all of us discount the interests of our ‘Morning Guy’. Night Guy reads that extra chapter; he watches another show on TV; he has another drink at the bar; etc. Why? Because it’s Morning Guy who ultimately pays the price. Night Guy is, in effect, maximizing his short-term utility at the expense of his long-term utility. And we all do it.
Morning Guy may curse Night Guy’s name, but by the time evening rolls around again, it seems that Day Guy has already forgotten the lessons learned by Morning Guy about appropriate Night Guy behavior, which leads to the cycle repeating itself: Night Guy parties; Morning Guy suffers; and Day Guy forgets. It’s a classic time inconsistency problem.
What we need to overcome this short-termism is some good and credible governance policy that will align the interests of Night, Morning and Day Guys. And we really have to write this policy down so that all the Guys can see what their behavior should be to maximize the interests of the entire individual. After all, we want to ensure that all the different Guys are working together to maximize the collective interests of themselves.
Now, let’s (try to) bring this back to institutional investment. Night Guy ultimately represents today’s generation of portfolio managers — they are naturally inclined to focus on returns over a short time horizon in order to maximize their own compensation. However, this behavior deviates from the long-term interests of the fund, which is represented by Morning and Day Guys. So the question then is how we discipline Night Guy (today’s employees) so he behaves in accordance with the interests of Morning and Day Guys too (the organization as a whole).
As you might expect, I think it’s all about governance. And, in particular, I think the compensation strategy (which I include under the umbrella of governance) is paramount. Why? Ensuring alignment of interests is all about getting the right mix of incentives to extend the individual’s time horizon as far into the future as possible.
But that’s easier said than done, which is why I was so tired getting out of bed this morning…
This post originally appeared on the Oxford SWF Project