Wall Street has a tendency to overemphasize short-term benefits at the expense of long-term benefits . . . There is a reward given to pursue short-term actions that provide a short-term benefit at the expense of long-term value to your company.

- Doug Geoga, Hyatt Hotels

I am a long term investor, but I find myself living in a short-term world. The stock market feels more like my manic ex-girlfriend: Always moody, always demanding performance, and totally unpredictable (Oh, and she took my money away too).

A few years ago, I came across a timeless article published by Legg Mason Capital Management. Frankly, I don't know anything about them other than the fact that they write damn good thought leadership articles. I would like to share it with you.

The article, "How Psychology and Incentives Shape the Investment Industry", was published in May 2006 by Michael J. Mauboussin and does a great job of explaining exactly why the market is so similar to my ex-girlfriend in the short term.

Mauboussin introduces the concept of Short Termism, which he defines as 'a heavy focus on short-term results'. It is not hard to think of examples of Short Termism when looking at the Markets (e.g. Investors dumping or buying up shares on earnings announcements, Day Traders, etc). Mauboussin continues to describe the causes of Short Termism as a consequence of Incentives (i.e. CEO Pay is More Tied to the Stock Price than Ever Before), Psychology (i.e. Human stress and fear response), Information (i.e. Media and Wallstreet are paid to generate information), and Rate of Change (i.e. The apparent acceleration of the rate of change for businesses creates a final source of shorter time horizons).

Short Term Sucks

Why do we care? Short term thinking sucks for a number of reasons:

There is Hope

But hold the phone kids. Mike Mauboussin is a glass half full kind of guy, and indicates that "Individuals who can, under the proper conditions, think and act with a long-term perspective stand to benefit from the short-term focus of others." However, he warns to not mix strategies by attempting to deliver superior long-term returns with strategies and behaviors rooted in short termism.

His big method for this is Time Arbitrage.

Scary name right? I know. But seriously, it is pretty simple stuff. Mauboussin uses the example of a coin toss to explain this. Check it: Mauboussin describes a coin toss where after 20 tosses, heads came up 35% of the time. That is the short term results. If you keep tossing the coin over and over, eventually you will get closer and closer to 50% chance of heads (or tails for that matter). Mauboussin's point is that the shorter the time horizon, the more 'noise' (volatility) you get which can deviate from the real long-term signal (Which is 50% in the case of the coin toss).

Time Arbitrage simply means that most investors (i.e. Bankers, individuals, and fund managers) tend to suffer from short termism, and therefore have high turnover or are trying to exploit very short-term anomalies in the stock market.

To summarize, Mauboussin is just stating that Time Arbitrage enables Value Investing (i.e. Buying good stocks at cheap prices).

I'm sure when people imagine the professional world of economics, they envision stout white men with male pattern baldness, sitting in a room jabbering about the Nikkei and suppressing the proletariat.

In actuality, it's more like a grown up version of the real world - cliques, disses and hookups are more common than people think. Like Coral was the real world roommate you love to hate, the "Real Bills Doctrine", the theory about the value of money and the cause of real inflation has been the whipping boy of the economics world for years.

Henry Thornton (1801), David Ricardo (1810) and Lloyd Mints (1945), espousers of the widely accepted "Quantity Theory of Money" and critics of the Real Bills Doctrine are the cast members that will stop at nothing to drive their pariah housemate into economic obscurity. However T.R.B.D. has the advantage of logic on its side.

For those who don't know, the Quantity Theory of money says that Currency as we know it only has value as a means of exchange and when you boil it down an American dollar is inherently worthless (See Fiat Money). Hence any creation of money, no matter the circumstances is inflationary.

M x V = P x T

The equation above is the backbone of the Q-theory. It stands for the quantity of money in circulation, multiplied by the velocity (the number of transactions in which the currency is used) is equal to the nominal price level multiplied by the aggregate real value of goods and services used in exchanges.

This is a tautology tantamount to " the rain that falls from the sky is the rain that hits the ground." There is no causal link in this model between the creation of money and inflation, it is just assumed that any creation of money is inflationary.

The conceit in this is that the types of money used to calculate inflation (M1 and M2) are just a portion of the money that is created in North America every day. Credit cards, food stamps, coupons, IOU's and sometimes even specially designed store currencies(Canadian tire dollars anyone?) exist and are exchanged for goods of real value, yet we don't have a huge unexplained jump in inflation due to the creation and use of these currencies.

How can this be while the quantity theory of money holds true? According to the Q-theory all of this currency creation should be incredibly inflationary and yet to date it remains ignored. Where the Q-theory of money fails the Real Bills Doctrine picks up.

In a nutshell, the Real Bills Doctrine says: Money created in exchange for "Real Bills" is not inflationary. Or, to put it another way, if you were to go to the US Mint and say "here is 100USD worth of gold" and they printed you 100USD, the creation of this money would not be inflationary. Why? Because the creation of money moved in step with the amount of assets under lock and key.

So you see, money that is backed by assets has worth because of the real value of the underlying assets. Doesn't that make more sense than magic worthless money that is somehow valuable because unconsciously we all agree that it's useful? There is no such thing as Fiat money.

Inflation happens when the underlying assets are destroyed or devalued. If a crazy US Mint employee destroyed half of the gold you gave for your printed money, there would only be 50USD worth of gold laying claim to 100 US paper dollars, hence the purchasing power of the paper dollars would be halved. Isn't that simple?

I've attached the paper that brought me to this school of thinking and it explains T.R.B.D. much more elegantly than I can. Most convincing are the historical examples that Sproul draws upon. I assure you if you read and digest it, it becomes very difficult not to see the logic staring you in the face.

http://129.3.20.41/eps/mac/papers/9711/9711001.html

The world is freaking out about the U.S. Recession. The doomsdayers and headline creators are leveraging the mass fear to gain a few extra clicks or newspapers (The linkbait reminds me of watching CNN).

I find it humorous that the The 'Wisdom' Journal website, posted a blog posting called 5 Ways I Plan To Survive The Recession. Don't get me wrong: The advice this blog offers is sound, and mirrors what I have been saying on this blog.

Here is the difference. The Wisdom Journal (and many other personal finance blogs) are giving the message that only in the face of a recession should one be concerned with eliminating debt, spending less than one earns, diversification and building an emergency fund.

All these actions are part of the 8 steps to build wealth slowly. If you follow them always, and not just in the face of a potential recession, then any economic jitters should worry you about as much as a hibernating bear.

Ups and downs. Boom and bust. This is the reality we live in, and you need to be prepared to survive in both by having good personal financial habits that don't change with the violitility of the econonmy or the market.