Short-Term Thinking Is a Long-Term Problem

MARCH 6, 2019

Short-Term Thinking is a Long-Term Problem

When it comes to snacking on marshmallows or saving for retirement, taking a long-term approach isn’t always easy because our brains are wired to think in the moment.

By Stelian Nenkov

WorldQuant, LLC 1700 East Putnam Ave. Third Floor Old Greenwich, CT 06870 www.weareworldquant.com 03.06.19 SHORT-TERM THINKING IS A LONG-TERM PROBLEM PERSPECTIVES

IN THE 1960s, PSYCHOLOGIST WALTER MISCHEL AND HIS COL- THINKING IN THE MOMENT leagues at Stanford University conducted a series of studies The MGI results wouldn’t come as a surprise to Larry Fink. The on delayed gratification, known as the marshmallow exper- chairman and CEO of asset management behemoth BlackRock has iment. The researchers presented four- and five-year-old been a vocal advocate for long-term investing for the better part of preschool children with one marshmallow apiece and told a decade. Recently, Fink has addressed not only the importance of them that they had two options: They could ring a bell at investing for the long haul but long-term thinking as a whole. He any point to summon the experimenter and eat the marsh- sees short-termism as an issue with undesired knock-on effects, mallow, or they could wait until the experimenter returned such as climate change, underfunded pensions and societal prob- — usually about 15 minutes later — to earn an extra marsh- lems. He argues that a new model for corporate governance is mallow. In other words, the children had to choose between needed — one that benefits all stakeholders. a small immediate reward and a larger later one. Fink is not alone. Other influential executives share his beliefs, Mischel and his team published their initial results on delayed including Berkshire Hathaway chairman and CEO Warren Buffett gratification in 1972,1 but the more interesting findings came in and JPMorgan Chase & Co. chairman and CEO Jamie Dimon. Last follow-up studies with the same group of subjects over the next year, Buffett, arguably one of the most successful investors of several decades. When the subjects were reevaluated as teenag- all time, teamed up with Dimon to write a Wall Street Journal ers and adults, those who had exhibited stronger self-control by op-ed3 in which they called for public companies to stop issuing waiting to eat the first marshmallow had higher SAT scores and quarterly earnings guidance. Their rationale: “Quarterly earnings lower body mass, and they used fewer drugs. Their ability to forgo guidance often leads to an unhealthy focus on short-term profits a short-term reward in favor of a higher future payoff seems to at the expense of long-term strategy, growth and sustainability.” have contributed to their well-being. Despite Mischel’s finding that thinking longer term leads to better The marshmallow experiment is one of the most famous pieces of outcomes — and the warnings by business leaders like Fink, social science research ever published. In the financial world, the Buffett and Dimon about the dangers of short-termism — taking rough equivalent was conducted by the McKinsey Global Institute a long-term approach isn’t easy. Our brains are wired to think (MGI), the research arm of consulting firm McKinsey & Co.2 MGI in the moment. This served us well from an evolutionary stand- studied 615 large and midcap publicly traded U.S. companies, point when we were hunter-gatherers foraging for food and trying measuring whether those that resisted the pressure to focus on to avoid being eaten, and modern technology has reinforced the short-term financial results performed better over the long haul. hardwiring by targeting our need for instant gratification (look MGI approached the study by devising the five-indicator Corporate no further than the alerts on your smartphone). Understanding Horizon Index, which aims to capture the span of a company’s how we got here is a good first step toward escaping this vicious focus. By computing the time-series index value for the companies cycle, but the solutions to the “new world” problems we face on a from 2001 to 2015, MGI found that those with long-term focus daily basis — investing responsibly, saving for retirement, sifting had, on average, 36 percent greater earnings growth than other through constant information flow — do not come naturally and companies, as well as higher revenue, market cap and profits. will require us to suppress our short-term instincts if they are to Those companies also had economic superiority: They created have a chance at succeeding. 11,600 more jobs, on average, during the period than did the shorter-term-focused enterprises. And even though long-term-focused When it comes to thinking long term, time is not on our side. To companies were hit harder than their shorter-term counterparts put things in perspective, consider that human evolution started during the 2008–’09 financial crisis, they recovered more quickly, approximately 4 million to 7 million years ago, and the human the MGI researchers found. brain as we know it today is almost identical to the roughly three- pound organ powering the firstHomo sapiens 200,000 years ago. We stopped living as hunter-gatherers only about 12,000 years ago; some 3,000 years later we discovered agriculture. Given the Our instinct to focus on the here enormous changes we’ve experienced in such a short period of time, it’s not surprising that the brains at our disposal have not yet and now served us well when we evolved to handle the dynamics of modern society, says Harvard were escaping predators, but it is University psychology professor Daniel Gilbert.4 “The brain and the eye may have a contractual relationship in which the brain not nearly as effective when we are has agreed to believe what the eye sees, but in return the eye making lasting investment decisions. has agreed to look for what the brain wants,” Gilbert writes in

his 2006 best seller, Stumbling on Happiness. The current human positive 93 percent of the time. If you look at the portfolio every brain developed in a world where people lived in relative isolation quarter, that number shrinks to 77 percent, and if you follow the and had short lives with few choices to make. The top priority was performance daily, it’s just 54 percent. If you check it every minute, to “eat and mate,” says Gilbert. Our instinct to focus on the here you will see only noise, as the odds of the return being positive or and now served us well when we were escaping predators, but it negative are roughly 50–50. Taleb’s example shows how easy it is is not nearly as effective when we are making lasting investment for investors to lose sight of the big picture over the short term. decisions. This is the essence of the problem with short-term When your investment objective is years, if not decades, away, thinking. As we live longer in more complex and interconnected checking progress every day is actually counterproductive. societies, short-term thinking is being displaced as the main factor for a successful and sustainable future; now long-term planning In 1979, psychologists Daniel Kahneman and Amos Tversky pub- is key for such achievements. lished their groundbreaking research on decision-making under risk.6 In this paper, they describe prospect theory, which attempts MISALIGNMENT OF INTERESTS to model how people make real-life choices when faced with uncer- A 2005 study of more than 400 CFOs by economists John Graham, tain outcomes. This is very different from classical economics, Campbell Harvey and Shiva Rajgopal found that nearly 80 percent which suggests that people are rational and always choose the of those surveyed admitted to willingly sacrificing economic value outcome with the highest expected utility. Kahneman and Tversky (as defined by positive net present value projects) to meet short- suggest that our brain reacts differently to potential gains and term earnings benchmarks.5 The researchers concluded that the losses. For example, a 1 percent drop in the value of a portfolio two primary factors contributing to this behavior are peer pressure is almost twice as painful as the pleasure derived from a 1 per- from competitors and investors’ expectations. The most surprising cent gain. Prospect theory suggests that we are more likely to discovery was that earnings smoothing was achieved by avoiding react emotionally simply by looking at our investment returns on investment opportunities, as opposed to manipulating accounting, a daily basis. which is very much in line with the findings of the MGI report. This also sounds strikingly similar to what Nobel Prize–winning econ- Of course, this does not mean that we should make as few deci- omist Richard Thaler describes as the “dumb principal” problem in sions in our life as possible or check our progress as rarely as we his 2016 book, Misbehaving: The Making of Behavioral Economics. can. After all, research has found that we learn skills by doing more Thaler explains that such an issue arises when a company fails and iterating our approach.7 Taleb’s example shows that there is a to create an environment in which employees are encouraged to link between a goal’s time frame and the frequency with which we undertake projects that have the highest positive expected utility. iterate our decisions — and that the two need to be logically con- This misalignment of interests — when the person responsible for nected. If we make retirement investments and check the results on a project is the one who gets punished if it fails to pay off, even if a daily basis, we are likely to start drawing inaccurate conclusions, the project adds positively to the diversification of the company’s and hence make poor choices, which will negatively impact our overall pool of activities — discourages employees from trying to investment goals, albeit unintentionally. maximize utility. Instead, it focuses their attention on safeguarding their jobs. HOT AND COLD Clearly, short-term thinking is largely embedded in our way of life. Because our brain cannot evolve faster than our environment, the Larry Fink argues that a new model question is whether it’s even possible to focus on the long term. The answer can be found in the writings of Kahneman, who was for corporate governance is needed awarded the Nobel Prize in economics in 2002 for his work on because the current system fails to prospect theory. He famously introduced to the masses the idea of dual-process theory in his 2011 best seller, Thinking Fast and perform well over the long term. Slow. Kahneman explains the distinction between the unconscious part of the brain responsible for thinking fast (System 1) and the Another practical illustration of investors’ fogged thinking stem- more deliberate part of the brain responsible for conscious rea- ming from short-termism is provided in Nassim Nicholas Taleb’s soning (System 2). second book, Fooled by Randomness. His example goes like this: Imagine that you have a portfolio expected to achieve 15 percent System 1 is emotional, automatic and mostly involuntary. And even annual returns with 10 percent annual standard deviation. The though as you read this you are probably thinking it’s the “bad” returns are normally distributed. Using Monte Carlo simulations, system responsible for us seeing only short-term advantages, if you check your portfolio once a year, the performance will be eating marshmallows and not investing for the future, System 1

plays a vital role in supporting our daily life. It is believed to derive and that it often is the single most important cause of delayed long- from our limbic (more primitive) brain system and, among other term investments in technology, human capital, and research and things, is responsible for localizing the source of a specific sound, development. To be clear, Buffett and Dimon are not arguing to end distinguishing that one object is at a greater distance than another quarterly reporting. As they note, transparency and accountability and understanding simple sentences — all key traits for surviv- are key to long-term economic growth. But the myopic focus by ing in the world thousands of years ago, and still critical today. many investors, analysts and executives on whether companies System 2 thinking is controlled by our prefrontal cortex. System 2, beat or miss earnings estimates seems to have mixed up the dif- Kahneman explains, is in charge of pointing our attention to some- ference between a quarterly goal and quarterly evaluations. one at a loud party, solving complex math problems and sustaining a higher than normal walking pace. When we are planning for the This clarion call builds on the Commonsense Corporate Governance long term, we are using our System 2 thinking. Principles (CCGP) proposed in 2016 by a group of two dozen leading U.S. executives and investors (including Fink, Buffett and Dimon). The two-system framework is useful for understanding the The principles are designed to get companies, their boards of marshmallow experiment. When analyzing the delay of gratifi- directors and their institutional shareholders to take “a long-term cation, Mischel and co-author Janet Metcalfe refer to Systems 1 approach to the management and governance of their business.” and 2 as, respectively, the hot and cold systems.8 Their research As the group noted in an open letter that accompanied the original shows that if a child does not manage to resist the urge to eat CCGP release, publicly traded companies represent only 5,000 of the marshmallow now, it does not guarantee that he or she will the U.S.’s 28 million businesses, but they account for a third of fail in life. Instead, it means that people need to learn the skills private sector employment and half of all business capital spend- necessary to achieve their goals. Correlation is easily mistaken ing, “both of which ultimately drive the productivity and health of for causation, and Mischel wants to make sure that his research the country.” 11 is not misunderstood.

In his 2018 annual letter to CEOs, BlackRock’s Larry Fink lays Digitization has led to the copious out the importance of long-term thinking for financial markets.9 He argues that a new model for corporate governance is needed creation of information to a point because the current system fails to perform well over the long never imagined. Our problem is no term, as measured by pensions, growth and beneficiaries. In Fink’s model, companies must benefit not only shareholders but longer a lack of information but the all stakeholders, including “shareholders, employees, customers overabundance of it. and the communities in which they operate.” In his view, this is best achieved by having a fundamental reason for existing — what Fink calls “a sense of purpose” — that is more than a witty marketing For investors, taking a long-term approach is more important than campaign or slogan. Such reasons are always long-term goals. ever, but technology — ironically — has made this more challeng- ing. In December 1982, Michael Bloomberg revolutionized the way Fink continues the narrative in his 2019 letter,10 drawing the con- financial information is disseminated among market participants nection between purpose and profits, much like MGI did in its 2017 when he introduced the first Bloomberg terminal. Since then, the report. Having a clear purpose unifies employees and sharpens steep decline in the cost of computing and the exponential growth focus and strategic discipline — and thus drives long-term prof- of the internet have allowed for the spread of information every- itability by creating value for all stakeholders. Fink contends that where. At the same time, smartphones have empowered more “clarity of purpose” helps people make rational long-term deci- than 2 billion people with real-time news and market data. All this sions rather than being seduced by short-term gains. Once you digitization has led to the copious creation of information to a point have a view on the horizon, it’s easier to place each decision into never imagined. Our problem is no longer a lack of information but a big-picture context. It’s this clarity that’s the source of strength the overabundance of it. Each information provider, in one form or needed to wait to earn a second marshmallow. another, is fighting for our limited attention, which is best obtained by tricking the most vulnerable part of our brain — the part seeking TRANSPARENCY AND ACCOUNTABILITY immediate gratification. In their 2018 Wall Street Journal op-ed, Buffett and Dimon also called for higher corporate governance standards. They urged com- The result is the creation of the infinite scroll, the red notification panies to steer away from providing quarterly earnings guidance, button in the corner of every smartphone app and the countless arguing that it causes “an unhealthy focus on short-term profits” short-term rewards put in place for everything from credit cards to

candy-crushing games. Companies are using what we’ve learned self-control — and the ability to regulate one’s own emotions — about the short-term inclination of the human mind not to move us involves a set of skills that can be taught, and learned,” he writes toward the long-term needs of the 21st century but instead to try in his 2014 book, The Marshmallow Test: Mastering Self-Control. to make us even more short-term focused by designing software “They’re acquirable. Nothing is predetermined.” to exploit our biases. This is yet another seemingly slow-chang- ing process, which we pay little attention to but which over an When things are not predetermined, they are subject to change. extended period leaves lasting impacts, increasingly feeding our And when change is on the table, the burden is on us to drive it in short-term tendencies. It’s hard to imagine people who check their the right direction. It’s this self-control that Fink, Buffett and Dimon stock portfolios on a daily basis to be focused patiently on long- have been advocating to both executives and investors.■ term investment results, as prescribed by Larry Fink. Stelian Nenkov is a Senior Quantitative Researcher at WorldQuant, For his part, Walter Mischel, who died last September at age LLC, and holds an MSc in financial risk and investment analysis from the 88, offers hope: “The most important thing we learned is that University of Sussex in the U.K.

ENDNOTES

1. Walter Mischel, Ebbe B. Ebbesen and Antonette Raskoff Zeiss. “Cognitive and 6. Daniel Kahneman and Amos Tversky. “Prospect Theory: An Analysis of Decision Attentional Mechanisms in Delay of Gratification.”Journal of Personality and under Risk.” Econometrica 47, no. 2 (1979): 263–292. Social Psychology 21, no. 2 (1972): 204–218. 7. K. Anders Ericsson, Ralf Th. Krampe and Clemens Tesch-Römer. “The Role of 2. McKinsey Global Institute. “Measuring the Economic Impact of Short-Termism” Deliberate Practice in the Acquisition of Expert Performance.” Psychological (2017). Review 100, no. 3 (1993): 363–406. 3. Jamie Dimon and Warren Buffett. “Short-Termism is Harming the Economy.” 8. Janet Metcalfe and Walter Mischel. “A Hot/Cool-System Analysis of Delay of The Wall Street Journal, June 6, 2018. Gratification: Dynamics of Willpower.” Psychological Review 106, no. 1 (1999): 3–19. 4. Daniel Gilbert. “Why We Make Bad Decisions.” TED Global 2005. https://www.ted.com/talks/dan_gilbert_researches_happiness 9. Larry Fink. “A Sense of Purpose.” BlackRock (2018). 5. John Graham, Campbell Harvey and Shiva Rajgopal. “The Economic Implications 10. Larry Fink. “Purpose & Profit.” BlackRock (2019). of Corporate Financial Reporting.” Journal of Accounting and Economics 40, nos. 1–3 (2005): 3–73. 11. Commonsense Principles of Corporate Governance (2016). http://www.governanceprinciples.org

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