Short-Termism and Long-Termism

Abstract

A significant debate in corporate law and finance concerns the role of activist investors (especially hedge funds) in corporate governance. Activists, it is often alleged, imprudently privilege short term earnings over superior (but less liquid) long term investments. Activists counter that they target managers who unjustifiably cling to questionable strategies. While this debate is hardly new, it has grown increasingly fractious of late. We analyze the activism debate within a theoretical securities-market setting. In our framework -- which draws from an emerging literature in empirical and experimental finance -- managers are differentially overconfident (causing them to favor long-term projects), while investors are differentially present-biased (causing them to favor short-term liquidity). We allow these biases to be either fundamental or induced by institutional factors, and they can occur either in isolation or in conjunction. Equilibrium behavior bears an uncanny resemblance to the ongoing activism debate, providing a new perspective on well-worn battle lines. Prescriptively, we demonstrate that short-termism and long-termism can have symbiotic attributes. Consequently, an "optimal" corporate law and governance regime should account for both effects, as well their possible interaction.

Keywords: Shareholder Activism, Hedge Funds, Managerial Overconfidence, Present Bias, Limits to Arbitrage

JEL Classification: C70, D72, G30, K22, L20