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Playing the Long Investment Game

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The first 20 pages of Michael Lewis’s wonderfully written book, Flash Boys, follows the secret project of a company called Spread Networks to lay 840 miles of “a-one-and-a-half-inch wide black plastic tube” in the most direct path possible between suburban Chicago and northern New Jersey. The sole purpose of this endeavor was to transmit data back and forth three to four milliseconds faster than any existing alternative. The owners of this cable project were able to spend nearly $200 million of their investors’ money because they were in contact with people willing and able to pay almost anything to access that four millisecond advantage.

The lucky customers of Spread Networks were smart and sophisticated investors who wanted to exploit a loophole in the existing regulations that would allow them to legally “front run” trades (i.e., have advance knowledge of other investors’ pending orders). Front running is the Wall Street equivalent of shooting fish in a barrel or having an extra key to the Bureau of Engraving and Printing. Spread Networks’ new fiber optic cable delivered incredible leverage to its customers, hitting the ultimate investment trifecta: riskless trades, huge profits and complete legality.

This is the short game: Get in, get out—make your profit, repeat as needed. Enormously attractive to the vast majority of investors, it eliminates the one thing investors are most uncomfortable with: uncertainty. It doesn’t matter if the profits are large or small (large are preferred) as long as the transaction is quick and done.

The bad news about the short game is that since everyone wants the same thing the pickings tend to be slim, and the few that are found either don’t last long or require a substantial combination of creativity, sophistication, opportunism and money. The enormous profits made by high-frequency traders only reinforced the lure of the short game. When the payoff is large enough there will always be people willing to risk whatever it takes—irrelevant either to the odds or the ethics.

For the rest of us there is the long game. Success at the long game requires overcoming considerable emotional and behavioral challenges; so it is far less popular among investors. But that means its abundant rewards haven’t been picked over.

Deep Time

Darwin’s last work was a 336-page book on worms and vegetable mold; an effort that some critics considered “a harmless work of little importance by a great naturalist in his dotage.” But Darwin was a keen observer. He wrote, “A worm’s work, when summed over all worms and long periods of time, can shape our landscape and form our soils.” Stephen Jay Gould argued that Darwin chose worms because they were the perfect way to reinforce the central thesis of his life’s work: “If they [worms], working constantly beneath our notice, can form much of our soil and shape our landscape, then what event of magnitude cannot arise from the summation of small effects.”

The San Andreas Fault runs 810 miles up the western side of California from the Mexican border ending just south of Oregon. It is formed by the boundary of two massive tectonic plates (Pacific and North American) as they move in opposite directions. The movement itself is barely enough to be measurable (less than an inch and a half each year)—geologists euphemistically call it “slippage.” A more popular and descriptive label is earthquake.

Here in Southern California, in the back of all of our minds is the knowledge that at some point “the big one” is going to strike. In human terms it is a legitimate and scary proposition. But from a geological perspective a single earthquake however large is a tiny cog in a big wheel. In eight to 10 million years and about 10,000 more “big” earthquakes, Los Angeles (or what’s left of it) will ultimately slide by San Francisco as the Pacific plate continues on its northwest journey. The leverage of deep time is what drives mountains into the sky and brings them down again in the perpetual remodeling of the earth.

Author John McPhee followed four geologists around the U.S. for 20 years interweaving their own personal stories with the amazing narratives hidden in rocks. He found that in order to do their work, geologists had to steep themselves in deep time—periods well beyond human experience or comprehension. Only within that paradigm was it possible to understand and explain how the sum of all these small changes formed the world that currently lies beneath our feet.

The leverage of time in the long game of investing is popularly characterized as a passive endeavor: “You don’t have to be smart—you just have to live long enough.” This is backed up with statistical evidence: The worst 30-year period in the history of the U.S. stock market still provided investors with a compounded annual return of almost 5%. There are considerable problems with this conclusion: The affairs of men are nowhere nearly as reliable or predictable as the processes of the natural world. And even if they were, statistically speaking, 130 years of stock market returns is not a robust enough data set to start betting the ranch with any legitimate confidence.

The real leverage in the long game of investing is us—through our decisions. We have all the power and we have all the leverage. We know this conclusively in a negative way from the numerous studies on investor behavior showing how bad choices over time leverage themselves into consistently poor long-term returns.

If investors’ consistently bad choices are penalizing their long-term results, that means that consistently good choices will enhance them. So there must be something specific and persistent that is keeping investors from making what, at the end of the day, are simple and common sense choices.

Daily Distractions

While considerable lip service is given to “investing for the long-term,” the overwhelming mindset in the investment world and the media is firmly devoted to the short game. Consider this recent quote from the research department of a well-known Wall Street firm: “The stock market has risen sharply, and it has become increasingly disconnected from the economy.” I have seen variations on this quote hundreds of times in my career, and cannot recall a single instance where it helped me make a solid long-term decision. In short, what the investment world and the media overwhelmingly serve up to investors is a distraction to a long-term mindset.

The distractions to solid long-term thinking are everywhere: newspapers, 24/7 cable news, unending amounts of online financial information, opinion and discussion. Investors have access to everything and anything they would ever want to know, except perspective.

The good news is that successful long-term investing (except for Warren Buffett and a handful of other elite investors) is much more a function of reducing our mistakes than it is coming up with brilliant strategic insights. In order to reduce mistakes we have to reframe our perspective from rationalizing them (a normal but unproductive response) to looking at them more clinically. Why did we make the mistake and how can we avoid repeating it? Little by little, mistake by mistake, we can slowly start to get out of our own way. After a while this practice becomes second nature and we can begin to access the substantial research on other investors’ mistakes and so avoid errors we haven’t even made yet.

Not only will we become better investors, the simple practice of persistently looking for mistakes naturally changes our mindset from short-term to long-term: a significant, but perhaps unexpected example of how an “event of magnitude” can arise from small effects.


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