“Good investing stems from matching assets to the eventual need to pay cash at a future date. True for individuals and institutions.”
So I said yesterday. A few people said to me that I needed to expand on that, and so now I expand.
The most common error in mismatching investment horizons is borrowing short to own long assets. We institutionalize this in the banking sector, though I believe it is a policy error to do so. Deposits should finance working capital, and not fixed capital. Long-term assets should be financed by long-dated loans or equity.
When you borrow on a short-term basis, where the terms are not locked-in, to buy a long dated asset, you take the risk that financing terms could move against you, changing that you can no longer hold the asset. This happens in asset bubbles, particularly toward the end.
It happens because it is the cheapest type of finance in the short-run, but often the most costly in the long run. Someone who pays up, and locks in lending terms for the life of the asset has far more predictability.
This is one reason why I try to analyze lending terms when analyzing manias. Typically, manias occur when enough people are willing to buy and finance a lot of it short term.
But, the opposite sometimes happens. There are some that will borrow long to invest short. We saw that in 2009-10, when companies were borrowing long to insure liquidity. Maybe you can consider it an insurance premium to make sure you stay alive as a company.
I have two other examples, both from the third insurance company that I worked for. In the middle of my time there, the company hired a consultant to analyze the investment policy of the company. The analyst had a big name, and he found that the company as a whole was mismatched short by two years.
If you are a well-run life insurer, you are either matched or as much as two years long. (I think a one-year gap between assets and liabilities is optimal, and so does Pimco.) It was a free lunch to lengthen the portfolio – returns increase, and risks decrease.
Sadly, or happily, depending on how you view it, in the annuity line of business that I was running two years later, after the first annuity withdrawal study was complete (one year ahead of the Society of Actuaries study, which mimicked my approach), I realized that the long-term guaranteed rates were significant, and I realized that the asset portfolio should be lengthened to reflect that.
I remember the investment department questioning me regarding putting 20% of annuity assets into 30-year bonds, and I said, “They hedge us against the long term guarantees.” They bought in, and it was another example where there was a free lunch – increase in income, decrease in cash flow risk.
On Investment Policy
This is why my most important question for investors is “When do you need the cash?” There is a gradation of approaches for maximizing returns with reasonable certainty in investing, and the approaches vary as the time horizon expands.
To all investors: try to match your investment strategy to the time that you need the money.
By David Merkel, CFA of Aleph Blog