The dimension of time in financial markets
The dimension of time in financial markets
A treatise on time and its effect on asset valuation. Know what TIME you are getting in at. What can move time up and down.
In this letter we will try to distinguish the dimension of time from financial markets, and discuss its power and influence in the financial arena.
In economics and finance the concept of time is captured in “time discounting” or “time preference”, which is defined as the current relative valuation placed on receiving a reward sooner rather than later.
With the risk of becoming too technical, discounting is the method used to value cash (or other rewards) that will be received in the future rather than in the present. In other words, $1 today is worth $1 today – but how much is $1 worth today when it will be received in two years time? That quantity can be understood through discounting.
The concept of discounting works well when companies use it in financial modelling for making decisions concerning borrowing, investing in new projects or other financial decisions.
However, the concept of time and discounting is fragile and can break down when applied to security valuation in financial markets. Why?
Markets sometimes discount 10 years forward, sometimes they discount 18 months forward and sometimes they completely break down (e.g. coronavirus bottom) and discount almost nothing. This shifting of discounting can take place uniformly over the global financial markets, for a specific sector of the economy, for a specific country or geography or even for a single company.
Why do we care about this? Because time has a tremendous influence on asset prices.
Before the coronavirus pandemic, markets were discounting equities (and other financial assets) many years into the future. Investors were optimistic about the future and were willing to pay up for rewards they expected to receive many years down the line. This can be described as “low time preference”.
In early 2020, markets started crashing as coronavirus fears hit. Investors were simply no longer willing to hold financial assets during a pandemic. Their time preferences shifted from low to high.
The economic environment was not good as most businesses had been shut and the ones that stayed open were under-operating. People did not know exactly how long the pandemic would go on, but it wasn’t as if a huge meteor hit the earth and destroyed everything. Besides, we had previous knowledge of pandemics and we knew that this would end some point in the next year or two.
But if investors had accepted a lower time preference before covid, why did they immediately change their time preferences when the environment changed?
Accepting a lower time preference implicitly means you are in it for the long term. It means you are looking far into the future and are willing to wait it out. Could it be that investors did not know what they were getting themselves into?
Let’s have a look at what can shift time preferences so drastically as paradigms change, cycles fluctuate and events unfold.
Fear
Uncertainty
Volatility
Doubt
Patience
Impatience
Optimism
Pessimism
Envy
Greed
Perceptions of risk
Urgency
Collective madness
Reactions to rare events (e.g. pandemics, global financial crises)
Interest rates and monetary policy
Expectations of interest rates
Cognitive biases
One can observe here that time preferences go through their own cycles as well. When times are good, investors are willing to pay a higher and higher price for the same future rewards (low time-preference), but as things turn sour they require a cheaper and cheaper price to exchange their cash for the same assets that they previously paid higher prices for (high time-preference).
It is self-evident from the above that time carries a tremendously important place in investing. Time can either hurt an investor or benefit him.
To illustrate the difference in risks and rewards when investing in low or high time preferences, let’s look at 3 scenarios.
Low Time Preference: The market is exuberant and positive and is not giving much thought to downside risks or things possibly going wrong in the future. Thus, it is looking far into the future and assigning a significant present value to rewards that will come in 5 to 10 years. Due to this, time is cheap and you are probably not getting a good enough price for the investment you are making. Some areas of the markets are extremely speculative and therefore dangers may lurk around the corner. Outside the hot parts of the market you could find good value and still make money, but you are probably not going to make a killing.
High Time Preference: The market is running on fear, uncertainty and doubt. It is focusing on the downside with little regard for future positive outcomes. Therefore, it is hesitant to price in any positive fundamentals and is not assigning a significant value to future rewards. Instead, it is mostly looking to the present and the near future when assessing asset values. As a consequence, time is expensive and intelligent investments made during these times could results in significant returns on capital going forward. Investors who previously departed with their cash to invest in a low time preference environment are now regretting.
Market Breakdown: The market is crashing like there’s no tomorrow, and that is exactly what securities are pricing in. Investors are completely focusing on a current event (financial crisis, pandemic etc.) that is indeed extremely serious, but not terminal for capitalism. Emotions are running high and survival is the prevailing driver of market sentiment. As a consequence, time is priced extremely high and the cooler heads that use this sell-off as an investment opportunity are bound to make amazing returns when markets normalise.
When allocating capital investors must be aware of the time preference environment that they are in and be ready to hold their positions as markets transition from one paradigm to the next. An investor will surely live through all three scenaria described above, and therefore must be ready to not only hold his conviction during trying times but also aim to increase his positions when opportunity is highest.
“Genius is eternal patience.”
-Michelangelo Buonarroti
great post!
Fascinating piece. It helped to crystalize for me an important intersection of some previously free-floating concepts and practical considerations.
However, I do feel compelled to challenge the statement "we had previous knowledge of pandemics and we knew that this would end some point in the next year or two." It mischaracterizes both the contemporary medical-scientific body of knowledge and the general public sentiment (scientifically informed or otherwise). Covid revisionism is commonplace; the phenomenon pervades discussions of this episode and certainly isn't unique to viral pandemics. In drawing attention to it here, I'm advocating heightened self-awareness in support of more responsible deployments of history.
If you look back at the record of the opening days and weeks of the outbreak, there were very few virologists, epidemiologists, vaccinologists, etc. willing to offer any such assurance that the threat to public health posed by SARS-COV-2 would be resolved within two years. Why? Because our experience with past pandemics, in fact, weighed against the many fortuitous assumptions required to predict a reassuringly brief onslaught, such as: that virulence wouldn't increase with broader transmission; that effective treatments and therapies would be devised; that a vaccine might be developed in months, rather than the typical years; that politicians would endorse a playbook of potentially draconian non-medical interventions and that these would be met with widespread compliance.
So, to the extent that realistic assessments and prudent advice from experts then still held sway, most people were sensibly bracing themselves for what might have been a much longer haul against a much graver threat. Our prospects, realistically rendered and appertained, were uncertain, at best.
Your statement implicitly indulges in hindsight-bias. It revises both the available facts and prevailing sentiments that obtained at outset of the Covid pandemic. To downplay those perceptions/assessments of the threat, criticize then-prudent decisions or valorize either ignorance of, or disregard for, informed assessments/guidance amounts to an endorsement of an attenuated response to some future contagion. Further, it subtly contributes to the maladaptive erosion of respect for expertise and authority in our political and intellectual culture.
The problem is that, like all dodged bullets, Covid actively invites us to draw the fallacious conclusions that teach the wrong lessons. It turned out to be, entirely by chance, an exceptionally mild-mannered and forgiving virus. COV-2 stands in benign contrast to pathogens such as its SARS predecessor, Spanish Flu, Ebola and MERS (not to mention the likes of Polio, Measles, Rubella, etc.). In those opening days, experts and authorities had every reason to take seriously the possibility of a 10% case fatality rate. That was the experience of SARS and MERS, the two most recent and biologically adjacent analogs. Ahead of epidemiological data--which, of course, becomes available only in the aftermath of widespread transmission--we didn't know that Covid wouldn't preferentially claim the lives of healthy young adults (as did Spanish Flu) or even children, killing 1%, 5% or perhaps more of the infected. The fact that Covid, instead, tended to "harvest" (to use the grimly actuarial term used by health economists) a high proportion of the elderly and premorbid in our population (and relatively few of them, at that) during a pandemic foreshortened by unprecedented innovations in vaccine development has made the entire episode surprisingly easy to accommodate ourselves to. It's very tempting to look back on those early dire warnings as alarmist and the public health interventions they motivated as unnecessarily burdensome. Because, if the experts are that clueless and authorities so obviously prone to overreach, next time we mustn't be so naive about things. Including our portfolios.
I don't mean to say that you haven't offered a useful framework for understanding the financial dimensions of time (and vice versa). But we need to be careful when we mine the past--our own, others' or shared--for lessons. Like memory, history domesticates events into tidy trains of causes and effects that satisfy our appetite for agency and control. The central problem for investors isn't to devise strategies that properly discount a reliable view of a singular future. Our challenge is to act in the face of competing renditions of the future that are, normally, diverse and somewhat mutually exclusive. Occasionally, the possibilities and prescriptions on offer are wildly divergent and diametrically opposed.
For the most part, our risk assessments and responses are largely our own remit. There are, however, a few notable exceptions. Leadership/stewardship is one. Personal behaviour with public health consequences is another. A third is published advocacy, advice or persuasion. In those cases, it's important for agents to appreciate the broadened scope of non-personal risks they are engaging, however deliberately or obliquely.
I wouldn't bother if I didn't respect the calibre of your work. Keep it up--it's a much appreciated contribution to the space.