The short-termism trap: Catering to informed investors with limited horizons

Introduction

Publicly traded firms face pressure from equity market investors with short investment horizons. This forces companies to make decisions that favor immediate gains over long-term value creation. But existing economic models of short termism cannot explain how this could be seriously damaging to the economy.  In our recent study, “The Short-Termism Trap: Catering to Informed Investors with Limited Horizons,” published in the Journal of Financial Economics, we present a model that illustrates how the short-term focus of informed investors can lead firms and the stock market into a destructive cycle of short-termism.

What is missing from existing models?

There are plenty of economic papers on short termism. They explain how shareholders, in order to monitor management, should require managers to demonstrate satisfactory performance at regular intervals, for example, by meeting earnings targets. To be sure, such targets will induce managers to sacrifice long-term value to meet the targets, to a certain extent. That is inevitable with any performance targets, since incentives can never be perfect and must always induce a certain degree of distortion. It does not mean those incentives should be abandoned. On the contrary, it is common sense that optimal incentives require a balance between better monitoring and the inevitable side effects.

That is not what we model. In contrast to existing models, our analysis shows how firms will be caught in a vicious circle, initiated by the stock market, that drags down long-term value creation as all firms engage in an ultimately futile attempt to out-do their peers with better short-term results.

The Short-Termism Trap: Economic Mechanism

The premise of our work is that informative stock prices improve firm value. For example, stock prices can improve managerial incentive contracts (the channel modelled in our paper) or other contracts, guide investment decisions, enable access to finance, and improve governance via activism or acquisitions. So, firms can benefit from going public and having their stock traded by well-informed traders. However, informed investors, such as hedge funds and proprietary traders, often have short horizons, driven by the need to demonstrate performance quickly or meet liquidity needs.

Under pressure from investor short-termism, firms can make their stock prices more informative by choosing short-term projects that cater to informed traders.  While this strategy might enhance stock price informativeness temporarily, it leads to a collective “race to the bottom” where all firms adopt excessively short-term projects. We show that this effect can even be so severe that it destroys 100% of the benefits of going public.

In other words, this behavior, although individually rational, results in suboptimal project durations across the market, undermining the potential long-term benefits of being publicly traded.

The “race to the bottom” in project maturity is driven by firms’ competition for informed investors. Here’s how the mechanism works. First, informed investors prefer firms that can provide quicker returns. To attract these investors, firms choose projects with shorter maturities, making their stock prices more reflective of short-term performance. Second, when a firm decides to pursue short-term projects, it increases its stock price informativeness at the expense of other firms. This is because the capital and attention of informed investors are finite. When one firm attracts more informed investors by shortening its project durations, fewer informed investors are available to analyze and invest in other firms, reducing the informativeness of their stock prices. This negative externality compels other firms to also shorten their project durations to retain or regain their attractiveness to informed investors: the decision of one firm to shorten its projects influences others to do the same. This strategic interdependence creates a feedback loop where the initial shortening by one firm induces others to follow suit, amplifying the trend towards short-termism across the market. As more firms shorten their project durations, the overall level of price informativeness across the market does not increase proportionately since the total amount of informed capital is fixed. Instead, competition merely redistributes the existing informed investors, leading to a situation where all firms have avoided long-term valuable projects in return for marginal short-term gains. This escalation of short-termist pressure results in the destruction of long-term value as firms collectively fail to invest in projects that would yield higher returns in the long run.

Implications

Our research provides several testable implications. Firms with higher proportions of short-term investors are likely to undertake shorter-duration projects and exhibit greater stock price volatility. This aligns with empirical evidence showing that stock-based compensation, while intended to align managerial incentives with shareholder interests, often leads to value-destroying short-termism. Because the origin of the short-termism trap lies in investor short-termism, policies aimed at lengthening managerial horizons, such as extending the vesting periods for stock options, may help mitigate these pressures but are unlikely to eliminate the short-termism trap entirely.

The presence of long-term investors can alleviate the short-termism trap to some extent. If a significant proportion of informed investors have long horizons, firms can afford to undertake longer-term projects that offer higher value over time. However, if long-term investors are too few, their influence is insufficient to counteract the prevailing short-term pressures. This suggests that regulatory and policy interventions encouraging long-term investment horizons among institutional investors could be beneficial.

The short-termism trap can lead to substantial value destruction. Our model benchmarks firm value against a scenario without stock market listing, showing that in equilibrium, the competition for informed investors can lead firms to make choices that offset all the potential benefits of having an informative stock price. It is often argued that going private enables firms to escape the short-termist pressure imposed by the stock market on publicly traded companies, and attain greater freedom to concentrate on long-term growth and innovation. (For example, in a letter to Tesla employees, Elon Musk noted that being public subjects Tesla to “wild swings in our stock price” and “quarterly earnings cycle” pressures, which can distract from long-term goals.) Our model supports this argument by showing that investor short-termism fosters a race-to-the-bottom among firms, where the associated costs can outweigh the benefits of price informativeness, encouraging some firms to remain private to avoid these detrimental effects.

Long-lived investors with limited capital often behave as if they have short horizons due to the opportunity cost of holding existing trading positions for extended periods. This opportunity cost is higher when a shock reduces price efficiency, making trading positions take longer to become profitable. Consequently, shocks originating in the financial market can transmit to inefficient real investment through the short-termism trap, leading to long-term negative impacts on the economy.

Figure 1. The Impact of Investor Short-Termism on Equilibrium Shareholder Value and Listing Decisions

*Left panel: As investor short-termism (x-axis) becomes more severe, the project maturity of firms (red dashed line) decreases and the fraction of unlisted firms (black line) increases.

*Right panel: As investor short-termism (x-axis) becomes more severe, the value of listed firms (black line) decreases and eventually collapses to that of unlisted firms (red dashed line)

Conclusion

The short-termism trap presents a significant challenge for publicly traded firms, driven by the short-term focus of informed investors. But existing economic models do not explain how this can arise in a way that inflicts economic damage. Our study elucidates the mechanisms of this trap and its detrimental effects on firm value. By understanding the dynamics of short-termism, we can develop more effective strategies and policies to promote long-term value creation in the financial markets.

We invite readers to explore our full paper on SSRN [here]. Through this research, we hope to stimulate further discourse on corporate governance and market efficiency.