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Abstract
“Time incongruency” occurs when there is a mismatch between the return period used to assess investment choices and an investor’s true investment horizon. Using both theoretical and empirical techniques, I demonstrate that time incongruency has a substantial impact on both the assessment of non-systematic and systematic risk, which can cause investors to make sub-optimal investment choices. I derive methods to mitigate this impact.
With non-systematic risk, the impact can emerge via the use of methods of analysis that are inappropriate for the investment horizon. This can cause investors to reach inappropriate conclusions about risk diversification opportunities, affecting their portfolio choices. For example, a long term investor may employ short run risk assessments in the form of pairwise correlation analysis, although long run risk assessments, including cointegration analysis, would be more appropriate. Using data from 12 Asia Pacific equity market indices drawn from a 23-year interval, I find many instances when such an investor would draw different conclusions about risk diversification opportunities under each method, suggesting that she could make sub-optimal investment choices.
In the case of systematic risk, time incongruency introduces a bias into the beta calculation. I show that this beta bias is a non-symmetrical function of the time congruent beta and the degree of time incongruency. As a result, this bias cannot be systematically diversified away across a portfolio. I derive, test and refine a solution, the “Adjusted Time Incongruency Beta Bias Adjustment (TIBBA) Model”, to mitigate this bias. I evaluate the benefits of this strategy using data drawn from four Asia Pacific markets over a 15-year interval.
Although most investors will not always have certainty around their true investment horizon, most will have a fairly clear expectation about their investment timeframe. By using this expected investment horizon to choose the most appropriate method of analysing non-systematic risk (correlation for the short run, or cointegration for the long run), they can reduce the impact of time incongruency on their risk diversification choices. Similarly, by using their expected investment horizon and the Adjusted TIBBA Model, they can choose appropriate asset allocation strategies to achieve their desired level of systematic risk across their portfolio.