Horizons
When is a trade an investment
A day late, summer posting may be irregular and weekly at most.
If there is a difference between theory and practice in portfolio construction, it is in the concept of investment horizons. The models practioners use are implicitly or explicitly adapted to their business, and though their “efficient frontiers” are quickly recognizable to students of finance, in practice every investor puts different terms on the axes of their risk-return diagrams. Because they look at risk differently, and because they have varying return horizons.
Modern Portfolio Theory (MPT) famously predicts every investor should have the same portfolio, just in different proportions depending on their aversion to risk and tolerance for leverage. This is very obviously not the case. It is a blind spot of the model, assuming that investors are interested in the same quantities at the same horizon. Whereas an investor statement (CFA has a template) begins with defining an investor’s specific goals and investment horizon!
Varying horizons not only explains varying portfolio holdings, it also underlies different opinions on investment opportunities. See for instance the discussion on “stranded assets”, fossil fuel investments that are incompatible with international agreements to limit climate change. If your horizon is 2050, these investments are likely to have zero terminal value. In the shorter term, in a world of growing energy needs and geoplitical uncertainties, these investments can seem very profitable.
Which brings me to the difference between a trade and an investment. For a long horizon, returns are dominated by the yield on the asset. For shorter horizons, the yield is secondary and the returns are driven by valuations at which the asset is bought and sold. Good trading can be very profitable but hardly good investment advice; long term investors recoil from assets with no cashflows like cryptocurrencies, gold, collectibles (art or Pokémon cards) and hype-stocks—and mock traders hoping to sell to a “greater fool”.
The recent news was that syndicating banks had managed to finally, and just in time, sell the debt they had underwritten (Yahoo Finance) for Elon Musk to acquire Twitter. This is an example of a trade becoming an investment: the banks’ intent was to earn structuring fees and offload risk asap, but they were left holding the bulk of the debt when no-one was willing to buy it. Musk’s short-lived stint near the center of American power improved the market’s estimation of X/Twitter’s credit and allowed the banks to close out without taking significant losses. Nonetheless the position performed poorly both as a trade—as originally intended—and as the investment they were grudgingly forced to accept.
As the writer of a publication called Slow Money (and as a user of BlueSky), I don’t need to tell you where I stand.