Equilibrium Short Horizons of Investors and Firms

An explanation is presented for why investors pursue short-term capital gains and firms select short-term investment projects. It is observed that, in practice, arbitrage is cheaper for assets that cannot stay mispriced for long than for assets that can. In equilibrium, the net expected return from arbitrage in each asset must be the same. Since arbitrage in long-term assets is more expensive than it is in short-term assets, the former must be more mispriced in equilibrium for net returns to be equal. Thus, the rational behavior of arbitrageurs leads to greater mispricing of long-term assets in equilibrium. Moreover, corporate managers are typically averse to severe underpricing of their equity because they risk being fired or taken over. They should then avoid investments that increase the cost of arbitrage of their equity. Since mispricing of claims to long-term investment projects can take a long time to disappear, such projects will be avoided. In this way, the short horizons of arbitrageurs lead to short horizons for corporate managers.