Harry G. Guthmann Professor of Finance; Co-Director, Financial Institutions and Markets Research Center
May 6, 2010 was just another day on the Dow Jones Industrial Average in New York—until 2:42 p.m., when a trading algorithm at a mutual fund executed an unusually large transaction, selling approximately $4 billion worth of assets.
Within minutes, the Dow, already down a few hundred points, plunged another 600 as high-frequency traders reacted to the shock. Blue-chip stocks like Accenture traded for pennies, while shares of Sotheby’s soared to $100,000. But by 3 p.m. the markets had recovered: all stocks returned to the vicinity of their original values.
This fifteen-minute crisis, dubbed the “Flash Crash,” highlights the importance of what Kellogg School finance professor Robert Korajczyk calls “horizon pricing.” An investment “horizon” generally refers to the timescale on which returns are harvested by investors. A venture capital firm, for example, may expect to be able to “exit” its investment in a tech startup in five years—through a sale or IPO, perhaps—with a return of ten times the original investment. Similarly, a 25-year-old setting up an IRA expects that a certain amount of value will have accrued when it is time to withdraw forty years later.
In the context of horizon pricing, however, “horizon” refers to something a bit different: the frequency with which an investor adjusts her investment positions and rebalances her portfolio. This frequency is crucial when it comes to assessing risk. To the high-frequency traders—whose portfolio positions are evaluated on a minute-by-minute (or even second-by-second) time horizon—the risk associated with holding shares in Accenture or Sotheby’s for those 15 minutes was enormous. With prices swinging wildly, every moment fortunes were made and lost.
“Buffett gets paid on a long horizon to accept risk that is measured on a short horizon.”
Meanwhile, “an investor that doesn’t do a lot of day trading probably didn’t even hear about the ‘flash crash’ until the next day,” Korajczyk says. That investor saw no risk at all, because the value of the stocks had already normalized over the longer time horizon.
New research by Korajczyk, along with Avraham Kamara of the University of Washington, Xiaoxia Lou of the University of Delaware, and Ronnie Sadka of Boston College (and a Kellogg School PhD-holder), investigates these different time horizons. Their study suggests that investors can earn a premium by acquiring assets that are riskier across other investment horizons than their own. A long-term investor, for instance, can benefit by snapping up stock that looks, in the short-term, unappealing.
“One of the primary questions in finance is, what is the extra premium I get for bearing risk?” explains Korajczyk. “To answer that, you need to ask how we can measure risk correctly using these different horizons that different investors care about.”
Korajczyk and his collaborators analyzed monthly stock prices for any company whose shares traded for at least $1 on the New York Stock Exchange, American Stock Exchange, or NASDAQ between August 1962 and December 2013: more than 17,000 unique companies in all.
They found that individual investors tended to have highly divergent trading horizons. A day trader’s horizon is quite short, since he judges market positioning and trades assets on a daily, or shorter, basis; a high-frequency trader’s horizons are shorter still. Meanwhile, a holding company like Berkshire Hathaway may only adjust its portfolio significantly on a horizon of years or even decades.
Korajczyk’s findings show that investors self-sort according to these horizons, and that they price “risky” assets accordingly. That is, high-frequency day traders will assess assets according to the risk involved in trading them on a daily or hourly schedule, rather than a monthly or yearly one.
Why do investors self-sort? Since nothing prevents, say, long-term investors from adjusting their positions on a short horizon, “why don’t we find more investors who do that?” Korajczyk asks.
In fact, it makes sense for many people to go years without changing their 401K allocations, says Korajczyk. The researchers found that these investors can earn a premium by holding the assets the short-horizon investors wish to avoid—all without bearing the short-run risk.
What this work suggests, says Korajczyk, is that the common wisdom about how to invest—that one should buy low and sell high—deserves an important corollary about when: a long-term investor should buy when investments are most out-of-favor with short-term investors.
Korajczyk cites the example of Warren Buffett making a large investment in Goldman Sachs during the height of the 2008 financial crisis. “Goldman Sachs needed funds, and Buffett was one of these investors who was under no pressure to trade,” he explains. “Buffett gets paid on a long horizon to accept risk that is measured on a short horizon.”
Not everyone possesses the additional acumen that tells Warren Buffett to make a bet on Goldman Sachs, which survived the financial crisis, versus Bear Stearns, which did not. But by understanding how risk—and the financial premium associated with bearing it—is defined by time horizons, investors can become more effective at achieving their goals.
For example, the 25-year-old setting up an investment retirement account may have a portfolio-rebalancing horizon of several years. In that scenario, selecting equity assets that are less liquid “makes sense—you’ll get compensated for that on the longer horizon because there are short-term investors with liquidity concerns who won’t want to hold it,” Korajczyk explains. Conversely, short-term investors can hold stocks whose investment payoffs will not be realized for many years since the risk is larger for the long-horizon investor.
But Korajczyk cautions against an oversimplified interpretation of his results. Warren Buffett may quip that his favorite holding period for stocks is “forever,” but “any given stock is never guaranteed to go up in the long run,” Korajczyk says. Instead, what matters is the timescale on which an investor is willing to bear risky positions within a diversified portfolio, and reap the associated financial benefits. We can’t all be Warren Buffett, but most of us can understand that much—and invest accordingly.
Kamara, Avraham, Robert A. Korajczyk, Xiaoxia Lou, and Ronnie Sadka. “Horizon Pricing.” Journal of Financial and Quantitative Analysis (JFQA). Forthcoming.