In the late 1960s, psychologist Walter Mischel and his colleagues at Stanford University conducted a series of studies on delayed gratification, known as the marshmallow experiment. The researchers presented four- and five-year-old preschool children with one marshmallow apiece and told them that they had two options: They could ring a bell at any point to summon the experimenter and eat the marshmallow, or they could wait until the experimenter returned — usually about 15 minutes later — to earn an extra marshmallow. In other words, the children had to choose between a small immediate reward and a larger later one.
Mischel and his team published their initial results on delayed gratification in 1972,1 but the more interesting findings came in follow-up studies with the same group of subjects over the next several decades. When the subjects were reevaluated as teenagers and adults, those who had exhibited stronger self-control by waiting to eat the first marshmallow had higher SAT scores and lower body mass, and they used fewer drugs. Their ability to forgo a short-term reward in favor of a higher future payoff seems to have contributed to their well-being.
The marshmallow experiment is one of the most famous pieces of social science research ever published. In the financial world, the rough equivalent was conducted by the McKinsey Global Institute (MGI), the research arm of consulting firm McKinsey & Co.2 MGI studied 615 large and midcap publicly traded U.S. companies, measuring whether those that resisted the pressure to focus on short-term financial results performed better over the long haul. MGI approached the study by devising the five-indicator Corporate Horizon Index, which aims to capture the span of a company’s focus. By computing the time-series index value for the companies from 2001 to 2015, MGI found that those with long-term focus had, on average, 36 percent greater earnings growth than other companies, as well as higher revenue, market cap and profits. Those companies also had economic superiority: They created 11,600 more jobs, on average, during the period than did the shorter-term-focused enterprises. And even though long-term-focused companies were hit harder than their shorter-term counterparts during the 2008–’09 financial crisis, they recovered more quickly, the MGI researchers found.
Thinking in the Moment
The MGI results wouldn’t come as a surprise to Larry Fink. The chairman and CEO of asset management behemoth BlackRock has been a vocal advocate for long-term investing for the better part of a decade. Recently, Fink has addressed not only the importance of investing for the long haul but long-term thinking as a whole. He sees short-termism as an issue with undesired knock-on effects, such as climate change, underfunded pensions and societal problems. He argues that a new model for corporate governance is needed — one that benefits all stakeholders.
Fink is not alone. Other influential executives share his beliefs, including Berkshire Hathaway chairman and CEO Warren Buffett and JPMorgan Chase & Co. chairman and CEO Jamie Dimon. Last year, Buffett, arguably one of the most successful investors of all time, teamed up with Dimon to write a Wall Street Journal op-ed3 in which they called for public companies to stop issuing quarterly earnings guidance. Their rationale: “Quarterly earnings guidance often leads to an unhealthy focus on short-term profits at the expense of long-term strategy, growth and sustainability.”
Despite Mischel’s finding that thinking longer term leads to better outcomes — and the warnings by business leaders like Fink, Buffett and Dimon about the dangers of short-termism — taking a long-term approach isn’t easy. Our brains are wired to think in the moment. This served us well from an evolutionary standpoint when we were hunter-gatherers foraging for food and trying to avoid being eaten, and modern technology has reinforced the hardwiring by targeting our need for instant gratification (look no further than the alerts on your smartphone). Understanding how we got here is a good first step toward escaping this vicious cycle, but the solutions to the “new world” problems we face on a daily basis — investing responsibly, saving for retirement, sifting through constant information flow — do not come naturally and will require us to suppress our short-term instincts if they are to have a chance at succeeding.
When it comes to thinking long term, time is not on our side. To put things in perspective, consider that human evolution started approximately 4 million to 7 million years ago, and the human brain as we know it today is almost identical to the roughly three-pound organ powering the first Homo sapiens 200,000 years ago. We stopped living as hunter-gatherers only about 12,000 years ago; some 3,000 years later we discovered agriculture. Given the enormous changes we’ve experienced in such a short period of time, it’s not surprising that the brains at our disposal have not yet evolved to handle the dynamics of modern society, says Harvard University psychology professor Daniel Gilbert.4 “The brain and the eye may have a contractual relationship in which the brain has agreed to believe what the eye sees, but in return the eye has agreed to look for what the brain wants,” Gilbert writes in his 2006 best seller, Stumbling on Happiness. The current human brain developed in a world where people lived in relative isolation and had short lives with few choices to make. The top priority was to “eat and mate,” says Gilbert. Our instinct to focus on the here and now served us well when we were escaping predators, but it is not nearly as effective when we are making lasting investment decisions. This is the essence of the problem with short-term thinking. As we live longer in more complex and interconnected societies, short-term thinking is being displaced as the main factor for a successful and sustainable future; now long-term planning is key for such achievements.
Misalignment of Interests
A 2005 study of more than 400 CFOs by economists John Graham, Campbell Harvey and Shiva Rajgopal found that nearly 80 percent of those surveyed admitted to willingly sacrificing economic value (as defined by positive net present value projects) to meet short-term earnings benchmarks.5 The researchers concluded that the two primary factors contributing to this behavior are peer pressure from competitors and investors’ expectations. The most surprising discovery was that earnings smoothing was achieved by avoiding investment opportunities, as opposed to manipulating accounting, which is very much in line with the findings of the MGI report. This also sounds strikingly similar to what Nobel Prize–winning economist Richard Thaler describes as the “dumb principal” problem in his 2016 book, Misbehaving: The Making of Behavioral Economics. Thaler explains that such an issue arises when a company fails to create an environment in which employees are encouraged to undertake projects that have the highest positive expected utility. This misalignment of interests — when the person responsible for a project is the one who gets punished if it fails to pay off, even if the project adds positively to the diversification of the company’s overall pool of activities — discourages employees from trying to maximize utility. Instead, it focuses their attention on safeguarding their jobs.
Another practical illustration of investors’ fogged thinking stemming from short-termism is provided in Nassim Nicholas Taleb’s second book, Fooled by Randomness. His example goes like this: Imagine that you have a portfolio expected to achieve 15 percent annual returns with 10 percent annual standard deviation. The returns are normally distributed. Using Monte Carlo simulations, if you check your portfolio once a year, the performance will be positive 93 percent of the time. If you look at the portfolio every quarter, that number shrinks to 77 percent, and if you follow the performance daily, it’s just 54 percent. If you check it every minute, you will see only noise, as the odds of the return being positive or negative are roughly 50–50. Taleb’s example shows how easy it is for investors to lose sight of the big picture over the short term. When your investment objective is years, if not decades, away, checking progress every day is actually counterproductive.
In 1979, psychologists Daniel Kahneman and Amos Tversky published their groundbreaking research on decision-making under risk.6 In this paper, they describe prospect theory, which attempts to model how people make real-life choices when faced with uncertain outcomes. This is very different from classical economics, which suggests that people are rational and always choose the outcome with the highest expected utility. Kahneman and Tversky suggest that our brain reacts differently to potential gains and losses. For example, a 1 percent drop in the value of a portfolio is almost twice as painful as the pleasure derived from a 1 percent gain. Prospect theory suggests that we are more likely to react emotionally simply by looking at our investment returns on a daily basis.
Of course, this does not mean that we should make as few decisions in our life as possible or check our progress as rarely as we can. After all, research has found that we learn skills by doing more and iterating our approach.7 Taleb’s example shows that there is a link between a goal’s time frame and the frequency with which we iterate our decisions — and that the two need to be logically connected. If we make retirement investments and check the results on a daily basis, we are likely to start drawing inaccurate conclusions, and hence make poor choices, which will negatively impact our investment goals, albeit unintentionally.
Hot and Cold
Clearly, short-term thinking is largely embedded in our way of life. Because our brain cannot evolve faster than our environment, the question is whether it’s even possible to focus on the long term. The answer can be found in the writings of Kahneman, who was awarded the Nobel Prize in economics in 2002 for his work on prospect theory. He famously introduced to the masses the idea of dual-process theory in his 2011 best seller, Thinking Fast and Slow. Kahneman explains the distinction between the unconscious part of the brain responsible for thinking fast (System 1) and the more deliberate part of the brain responsible for conscious reasoning (System 2).
System 1 is emotional, automatic and mostly involuntary. And even though as you read this you are probably thinking it’s the “bad” system responsible for us seeing only short-term advantages, eating marshmallows and not investing for the future, System 1 plays a vital role in supporting our daily life. It is believed to derive from our limbic (more primitive) brain system and, among other things, is responsible for localizing the source of a specific sound, distinguishing that one object is at a greater distance than another and understanding simple sentences — all key traits for surviving in the world thousands of years ago, and still critical today. System 2 thinking is controlled by our prefrontal cortex. System 2, Kahneman explains, is in charge of pointing our attention to someone at a loud party, solving complex math problems and sustaining a higher than normal walking pace. When we are planning for the long term, we are using our System 2 thinking.
The two-system framework is useful for understanding the marshmallow experiment. When analyzing the delay of gratification, Mischel and co-author Janet Metcalfe refer to Systems 1 and 2 as, respectively, the hot and cold systems.8 Their research shows that if a child does not manage to resist the urge to eat the marshmallow now, it does not guarantee that he or she will fail in life. Instead, it means that people need to learn the skills necessary to achieve their goals. Correlation is easily mistaken for causation, and Mischel wants to make sure that his research is not misunderstood.
In his 2018 annual letter to CEOs, BlackRock’s Larry Fink lays out the importance of long-term thinking for financial markets.9 He argues that a new model for corporate governance is needed because the current system fails to perform well over the long term, as measured by pensions, growth and beneficiaries. In Fink’s model, companies must benefit not only shareholders but all stakeholders, including “shareholders, employees, customers and the communities in which they operate.” In his view, this is best achieved by having a fundamental reason for existing — what Fink calls “a sense of purpose” — that is more than a witty marketing campaign or slogan. Such reasons are always long-term goals.
Fink continues the narrative in his 2019 letter,10 drawing the connection between purpose and profits, much like MGI did in its 2017 report. Having a clear purpose unifies employees and sharpens focus and strategic discipline — and thus drives long-term profitability by creating value for all stakeholders. Fink contends that “clarity of purpose” helps people make rational long-term decisions rather than being seduced by short-term gains. Once you have a view on the horizon, it’s easier to place each decision into a big-picture context. It’s this clarity that’s the source of strength needed to wait to earn a second marshmallow.
Transparency and Accountability
In their 2018 Wall Street Journal op-ed, Buffett and Dimon also called for higher corporate governance standards. They urged companies to steer away from providing quarterly earnings guidance, arguing that it causes “an unhealthy focus on short-term profits” and that it often is the single most important cause of delayed long-term investments in technology, human capital, and research and development. To be clear, Buffett and Dimon are not arguing to end quarterly reporting. As they note, transparency and accountability are key to long-term economic growth. But the myopic focus by many investors, analysts and executives on whether companies beat or miss earnings estimates seems to have mixed up the difference between a quarterly goal and quarterly evaluations.
This clarion call builds on the Commonsense Corporate Governance Principles (CCGP) proposed in 2016 by a group of two dozen leading U.S. executives and investors (including Fink, Buffett and Dimon). The principles are designed to get companies, their boards of directors and their institutional shareholders to take “a long-term approach to the management and governance of their business.” As the group noted in an open letter that accompanied the original CCGP release, publicly traded companies represent only 5,000 of the U.S.’s 28 million businesses, but they account for a third of private sector employment and half of all business capital spending, “both of which ultimately drive the productivity and health of the country.” 11
For investors, taking a long-term approach is more important than ever, but technology — ironically — has made this more challenging. In December 1982, Michael Bloomberg revolutionized the way financial information is disseminated among market participants when he introduced the first Bloomberg terminal. Since then, the steep decline in the cost of computing and the exponential growth of the internet have allowed for the spread of information everywhere. At the same time, smartphones have empowered more than 2 billion people with real-time news and market data. All this digitization has led to the copious creation of information to a point never imagined. Our problem is no longer a lack of information but the overabundance of it. Each information provider, in one form or another, is fighting for our limited attention, which is best obtained by tricking the most vulnerable part of our brain — the part seeking immediate gratification.
The result is the creation of the infinite scroll, the red notification button in the corner of every smartphone app and the countless short-term rewards put in place for everything from credit cards to candy-crushing games. Companies are using what we’ve learned about the short-term inclination of the human mind not to move us toward the long-term needs of the 21st century but instead to try to make us even more short-term focused by designing software to exploit our biases. This is yet another seemingly slow-changing process, which we pay little attention to but which over an extended period leaves lasting impacts, increasingly feeding our short-term tendencies. It’s hard to imagine people who check their stock portfolios on a daily basis to be focused patiently on long-term investment results, as prescribed by Larry Fink.
For his part, Walter Mischel, who died last September at age 88, offers hope: “The most important thing we learned is that self-control — and the ability to regulate one’s own emotions — involves a set of skills that can be taught, and learned,” he writes in his 2014 book, The Marshmallow Test: Mastering Self-Control. “They’re acquirable. Nothing is predetermined.”
When things are not predetermined, they are subject to change. And when change is on the table, the burden is on us to drive it in the right direction. It’s this self-control that Fink, Buffett and Dimon have been advocating to both executives and investors.
Stelian Nenkov is a Senior Quantitative Researcher at WorldQuant, LLC, and holds an MSc in financial risk and investment analysis from the University of Sussex in the U.K.
1 Walter Mischel, Ebbe B. Ebbesen and Antonette Raskoff Zeiss. “Cognitive and Attentional Mechanisms in Delay of Gratification.” Journal of Personality and Social Psychology 21, no. 2 (1972): 204–218.
2 McKinsey Global Institute. “Measuring the Economic Impact of Short-Termism” (2017).
3 Jamie Dimon and Warren Buffett. “Short-Termism is Harming the Economy.” The Wall Street Journal, June 6, 2018.
4 Daniel Gilbert. “Why We Make Bad Decisions.” TEDGlobal 2005. https://www.ted.com/talks/dan_gilbert_researches_happiness
5 John Graham, Campbell Harvey and Shiva Rajgopal. “The Economic Implications of Corporate Financial Reporting.” Journal of Accounting and Economics 40, nos. 1–3 (2005): 3–73.
6 Daniel Kahneman and Amos Tversky. “Prospect Theory: An Analysis of Decision under Risk.” Econometrica 47, no. 2 (1979): 263–292.
7 K. Anders Ericsson, Ralf Th. Krampe and Clemens Tesch-Römer. “The Role of Deliberate Practice in the Acquisition of Expert Performance.” Psychological Review 100, no. 3 (1993): 363–406.
8 Janet Metcalfe and Walter Mischel. “A Hot/Cool-System Analysis of Delay of Gratification: Dynamics of Willpower.” Psychological Review 106, no. 1 (1999): 3–19.
9 Larry Fink. “A Sense of Purpose.” BlackRock (2018).
10 Larry Fink. “Purpose & Profit.” BlackRock (2019).
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