What is long-term investing? Who is a long-term investor? What does being a long-term investor imply for investment strategy? Let us consider these questions, in turn.

So what is long-term investing? The obvious answer is investing when the aim is maximisation of a risk-

adjusted value (or income stream) far into the future.

This definition of long-term investing has two

implications.

First, in the short to medium run, the liquidity of the assets – that is the ease and cost at which they can be converted into other assets or finance consumption – is likely be relatively unimportant, except to the extent that such illiquidity affects their final value. It will

indeed do so if investors end up trapped in poorly

performing assets.

Second, the further ahead one peers, the greater fundamental uncertainty – or “unknown unknowns”, in Donald Rumsfeld’s famous phrase – is bound to be. The world, as Nassim Nicholas Taleb, author of The Black Swan, has noted, is a surprising place.

Now let us consider the second question: who are the long-term investors? They seem to fall into three classes, with correspondingly different attitudes to risk and rewards.

The first class is immortal institutions, such as

universities, churches and many foundations and charitable endowments. Today, that class would include governments (both national and sub-national). The oil-exporting countries, in particular, have very long-term investment horizons indeed, since they are converting one asset – oil under the ground – into other income-generating assets.

The second class of long-term investors is collective institutions designed to provide security in old age for their members, namely, pension funds, be they self-standing or sponsored by some other organisation, such as a company.

The final class is individuals who are trying to shift consumption from their period of work to a period of retirement.

Now turn to the third question: what does being a long-term investor imply for investment strategy?

In the first place, the risks these different long-term investors are able or willing to bear differ. An individual saving for his or her own retirement is relatively risk -averse, for example: ending up with nothing would normally be an unacceptable option even if there were a chance that the strategy which led to this unhappy outcome might create substantial wealth. (Of course, a generous welfare state might reverse that calculation.)

Equally, the costs of diversification (and administration) are far higher for small individual investors than for institutions. Moreover, they also do not have access to the best investment advice. For all these reasons, expected returns on small portfolios are likely to be relatively low and defined contribution pension savings by individuals likely to perform poorly.

Institutions with both large wealth at their disposal and long-term horizons are in a better position to diversify and achieve high returns. They also have access to better advice. But they, too, are unlikely to be indifferent between massive losses and equivalent gains: the president who gambled away the Harvard endowment would enter the annals of infamy.

In the second place, long-term investors must recognise that there are no absolutely safe investments, while the safest investments also give very low real yields.

The closest investors can come to a safe asset is index-linked bonds issued by highly-rated governments. The longest index-linked bond issued by the British government, for example, matures in November 2055, but pays only 1¼ per cent. Outright default or tinkering with the inflation indices (as is happening today in Argentina) is always a possibility, however unlikely (one hopes). Nominal bonds are extremely vulnerable to inflation, as became evident after the second world war across much of the world.

In the third place, the best-performing investments over the past century have been real assets, particularly equities (though property values also gain from high economic growth). But one must avoid being misled by survivor bias, as Mr Taleb would stress. Many markets one might have believed in a century ago disappeared for long periods.

Yet the case for an expected outperformance of equities over bonds seems clear. Professors Elroy Dimson, Paul Marsh and Mike Staunton have shown that such outperformance was the story of the 20th century.* John Campbell of Harvard University estimates that “the world geometric average equity premium was

almost 4 per cent at the end of March 2007, implying a world arithmetic average equity premium somewhat above 5 per cent.”**

Nevertheless, even here there are two qualifications. One is that returns on equities are volatile in the short to medium run. Investors needing to fund a substantial stream of expenditure in the medium run might fear drawing down so much of their capital during a market downturn as to impair its value substantially.

Another qualification is that returns are mean-

reverting: periods of high returns tend to be followed by periods of low returns. This is closely related to the fact that valuations of underlying assets (and cyclically adjusted returns) are also mean-reverting: movement towards high valuations are followed by movement towards lower ones. This matters at the moment because cyclically-adjusted valuations in mature markets are high by historical standards, even though current ratios of prices to earnings do not appear exceptional.

Thus, a broadly diversified equity portfolio makes sense for long-term investors, provided they take account of mean-reversion. But what should they do about other assets? Emerging market equities are relatively high risk, but should offer relatively high

returns. Private equity is merely a relatively risky and so, with good judgment, higher return way of holding corporate assets. Hedge funds are as good as their managers and their diverse strategies. The big point is that long-term investors ought to be able to pick up attractive returns. There is some evidence that the market overestimates the riskiness of equities, further justifying holding them. But equities are exposed to all kinds of political and economic risks and uncertainty. Let investors beware.

*”Triumph of the Optimists”, Princeton University Press, 2002

**“Estimating the Equity Premium”, Working Paper 13423, September 2007, National Bureau of Economic

Research, www.nber.org