Yes, I understand the odds are your first reaction to this post is “what the blank are temporal preferences?“. Let me explain.

Temporal is just a fancy word for time. So temporal preferences is the academic way of saying people have different time horizons when making decisions. Think of long vs. short term investors.

Note, this is different from the temperament differences Buffett discusses. Those have to do with why he can make money and you can’t!

Your next question is probably “why the blank do I care?“. Because a lot of things that happen in the real world that “don’t make sense” make perfect sense to someone with a different time horizon than you or I.

An Example

Let me start with an easy example. Take a company who needs to raise equity. The existing shareholders don’t want it to. However, a savvy investment banker enters the picture. He tells the company he can raise the capital “overnight” from new investors.

Why would these new investors want to buy a stock that is about to experience dilution? Because the bankers convince the company to sell it at a small discount, say 2 or 3%. These new investors could care less about the company or what it does. They figure there is a good chance they can make a quick 2% and get out.

The banker has exploited a temporal difference between the core shareholders and the traders who bought the overnight deal. The investment bank is happy because they made a fee. The CEO is happy because the equity got raised. The existing shareholders are unhappy but their only option is to dump their stock out of frustration at a loss.

Now, while it’s easy to paint greedy investors and Wall Street bankers as exploiting temporal preferences, let’s be honest, it happens everywhere. Why do managers make decisions that help short term growth (which drives their bonus) but hurt long term profitability (which only emerge after they’ve moved to a competitor)?

Why do politicians only focus on the next election rather than say fixing Social Security? Why do coaches on the hot seat trade their best young players for past their prime veterans? Look around and you’ll find temporal differences everywhere!

Blowing Bubbles

So where I am going with all this? Temporal preferences are a big driver of investment bubbles. Those perpetuating the bubble have very short term horizons. Those screaming about the pending doom have longer horizons. Bubbles form when the usual equilibrium between short and long tilts severely towards the short end.

I’ve talked a number of times about the excessive risk taking brought on by aggressive Fed policy. When monetary policy is too loose, the equilibrium tilts toward the short end and we get bubbles.

If you know with certainty we are in a bubble environment and the end is not imminent, it can actually be “rational” to invest in companies you are certain will die – as long as you have the liquidity to sell after you’ve made your quick buck and don’t have to hold until “reality” is revealed.

Similar to the overnight equity structure outlined above, an “insolvent” company can achieve solvency by taking advantage of the short term funding environment.

Those with long memories will recall this is what the insurance industry did in the mid 80s. Technically insolvent companies (if reserves were marked to market) were able to grow their way out of their hole given the pricing improvement.

One of the things I talked about in the tortoise vs. the hare was the advantages the hare creates by having an inflated currency to fund growth. When the temporal equilibrium is tilted towards bubble blowing, it is a lot easier to be the hare.

The Fed has given the hare a tailwind that the tortoise doesn’t presently have. Remember, if the hare raises enough cheap money, it can will itself to success even with subpar execution.

If you are one of those inclined to look at the long term, my advice for you is simple. Be patient. All bubbles end. The key to surviving a bubble is to be solvent at the end to take advantage of all the new opportunities created by the wreckage (e.g. distressed investing).