In a world where investors have heterogenous discount rates, the market portfolio is only optimal when the investors discount rate is equal to the market discount rate.
For many long-terrm investors this is unlikely to be the case, as evidence suggests price formation is driven by short-term investors. While for obvious reasons it is incredibly complex (and perhaps borderline impossible) to distinguish individual discount rates from that of the market (and some parts of the academic community would argue it is irrational to have heterogenous discount rates), and to disentangle market perceptions of future cash flows and the way they are discounted, the presence of such heterogeneity implies that long-term investors are likely to systematically engage in suboptimal investing strategies.
The findings build on previous work by Theia Finance Labs identifying key shortcomings and challenges of modern index design (Read the Report, “Cabinet of Curiosities” here) and our survey of 60 institutional investors to define what it means to be a long-term investor (“What does it mean to be a long-term investor?”), demonstrating a signiicant gap between the label “long-term investor” investors give themselves and the actual investment practices.
The bias of market portfolios vis-a-vis long-term investors has significant implications for investing but also for climate.
It suggests that market-cap weighted indexes may not represent an optimal investing strategy for long-term investors. To date, institutional investors looking to integrate climate into their index strategies have looked at low-carbon alternatives that build off of a parent benchmark. As this research shows however, it may be time to challenge the notion of market-cap weighted parent benchmarks as well.
As part of the broader evolution of its research programme, Theia Finance Labs is releasing a new research series of so-called ‘academic working papers’ starting with this analysis of the impact of heterogenous discount rates on optimal investing strategies. We hope you enjoy it!
These working papers are for a technical audience interested in exploring ‘academic-style’ analysis related to climate change, finance, and long-term risks. There is no fancy cover page and infographics and flashy executive summaries. We feel it is important to strengthen our research portfolio with more deep-dive, long-form, analytical work. That does not mean we want to compromise on impact or readership. We hope to convince our subscribers and stakeholders that exploring this body of research is worth their time!
