MAXIMIZING RATES OF RETURN
If there is one lesson that my 50 years or so of investment experience has taught me it is that the longer the average investment in a given portfolio, the greater the overall long term rate of return for that portfolio. Some of this is due to saving transaction costs and some to the difficulty of "rolling over" short term investments to equivalent yields.
If there is a second lesson it is that the greatest risk in most investments is PREPAYMENT RISK. Prepayment of course shortens the life of an investment, and thus to some extent is subsumed in short term investment risk.
The types of investments exposed to prepayment risk are essentially mortgage investments and callable securities. Since there are various statutory and regulatory restrictions on prepayment penalties for residential mortgages, residential mortgages have a huge risk of prepayment if there is much chance of refinance rates becoming more attractive than existing loan rates. A lot of modeling has be done to quantify this risk, and in fact there are investment products (interest and principal strips) that can be used to hedge this residential mortgage prepayment risk.
The best way to avoid this residential mortgage prepayment risk is however to not invest in residential mortgages. They are highly regulated and don't pay much interest anyway. Similarly, bonds, also with a low rate of return, are generally to be avoided, especially if they ache a call provision.
In mortgage lending the periodic rate of return tends to be higher for shorter term paper: borrowers are willing to pay a higher interest rate when they figure they are not apt to be saddled with it for a long period of time. Shorter term mortgages however take just as much time and expense to originate as longer term mortgages, and this origination expense, unless balanced by origination fees anyway, has to be amortized over the life of the loan. When the shorter term loan pays off there is an appreciable risk that the funds cannot be immediately reinvested advantageously. There is however always the possibility that the funds can be reinvested at a HIGHER rate of return.
Household Finance many years ago recognized that the best way to minimize prepayment risk was to always send a check to increase the size of a loan when the equity in the property increased or the debt had been paid down. Most people would just take the check, increasing their loan balances to a level that could not easily be refinanced. While this of course increased the LTV of Household's portfolio, it also invested new money at a high rate of return in loans to customers with a proven ability and willingness to pay. Thus, the duration of investments was greatly increased while the default characteristics of the portfolio ere greatly improved (at least as long as values continued to rise!!)
One of my large national lender clients favored "peanut behind the elephant" loans (essentially small loans at 105% LTV or something at high rates behind large first mortgages) on the theory that these loans would have (a) a high yield and (b) a long duration. Interestingly when a steep decline in values occurred and LTV's rose to 125% or more, the IRR of this portfolio actually IMPROVED since prepayment experience entirely ceased while non performance remained containable. While a containable percentage of homeowners "crammed down" their loans in Chapter 13 bankruptcies the percentage of people who either kept on paying, or ended up paying a large payoff when the value of their homes had increased again. was sufficiently high as to result in an overall IRR for this portfolio which exceeded all expectations.
Warren Buffett is right: keep your money invested in good situations for as long as possible at as high a rate of return as I prudent without seriously risking capital. Obviously, when you become uncertain how good an investment is, get out of it as cheaply as possible and go look for a better one. reducing the risk of capital.