Ben Carlson had a great post on Sunday, covering a part of an interview with Cliff Asness in which he discusses a key difference between academic and a practitioner approaches. I wanted to focus on an element of the quote Ben used:
Well the single biggest difference between the real world and academia is — this sounds overly scientific — time dilation. I’ll explain what I mean. This is not relativistic time dilation as the only time I move at speeds near light is when there is pizza involved. But to borrow the term, your sense of time does change when you are running real money. Suppose you look at a cumulative return of a strategy with a Sharpe ration of 0.7 and see a three year period with poor performance. It does not phase you one drop. You go: “Oh, look, that happened in 1973, but it came back by 1976, and that’s what a 0.7 Sharpe ratio does.” But living through those periods takes — subjectively, and in wear and tear on your internal organs — many times the actual time it really lasts. If you have a three year period where something doesn’t work, it ages you a decade. You face an immense pressure to change your models, you have bosses and clients who lose faith, and I cannot explain the amount of discipline you need.
In investing, it may be useful to consider the impact of our perceptions of time. Cliff recognizes that time is flexible in several respects.
As he points out, in physics, time dilation refers to how time passes at different rates depending on one’s inertial frame. For instance, if Cliff is traveling at near light speed going for another slice of pizza, an hour for him might represent, say, a day for someone standing still. Two clocks in those separate inertial frames will literally move at different rates.
But time dilation is also a psychological concept, which in a sense is just as real as it is in the physical world.
For instance, it has been observed that people of different ages subjectively experience the passage of time at different rates. For older people, time passes more quickly than for younger people. There have even been some attempts to quantify this. Using various experimental methods, some have proposed that the acceleration of time varies inversely with the square root of one’s age. So for example, time passes twice as quickly for a 64 year old (1/64^0.5 = 0.125) as it does for a 16 year old (1/16^0.5 = 0.25).
Thus, in psychology, as in physics, time is relative to your frame of reference. Likewise, our perception of time can affect our choices through “present bias,” a kind of temporal myopia we can experience. We “tunnel” on the present, and value it more highly than the past or the future.
Cliff uses the example of an investment strategy that shows a three year period of poor performance.
This sounds a lot like value investing.
As Cliff notes, it is one thing to look at a series of return outcomes on a page, and note clinically and dispassionately that value underperformed for a 5 year stretch in the 90s. Conceptually, or in an academic setting, that is an abstract notion, and at least partly because it is remote in time, that stretch of time does not seem to be a notably lengthy period when viewed in a broader context.
It is another thing entirely to have a large chunk of your net worth allocated to a value strategy as you watch drawdown after drawdown occur in real time versus the benchmark over a period of years.
Yet why should these experiences of time be so different? Partly this relates to having money at risk. That’s certainly true. But it’s also about how we perceive time. A stretch of time that is temporally far away is more short-lived than a similar stretch experienced today. Value underperformed for a few years long ago — so what?
In, say, a car accident, people describe how time slows down, as the brain layers dense memories. Similarly, during a poor investing environment, time dilates as losses become more and more salient and we increasingly overweight the present, which is highly available. Time dilation might also cause us to increase discount rates for future returns. The result? There is no future return which, when discounted, can offset the increasing pain of further potential losses, and we capitulate and sell just when we shouldn’t. So in addition to money at risk, changes in how we perceive time may also influence our decision making.
In our post, The Sustainable Active Investing Framework: Simple, But Not Easy, we describe how an understanding of behavioral bias is critical to achieving long term success. There are a number of biases, but perhaps it’s appropriate to think more carefully about how our perceptions of time can affect our investment decision making.