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 short- er-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 Copyright © 2019 WorldQuant, LLC March 2019 2 03.06.19 SHORT-TERM THINKING IS A LONG-TERM PROBLEM PERSPECTIVES 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.