The role future expectations play in investment returns
We believe investors should focus on long holding periods.
The stock market is simply a mechanism for millions of buyers and sellers to come together to transact.
A transaction is simply an agreement. Both the buyer and the seller are agreeing on something – and the central thing they are agreeing on is the price. As there are changes in prices different people decide to buy or sell based on that price. Even though market prices change all the time, for a split second the price of a share or the level of an index represents the equilibrium of supply and demand.
This means that share prices or index levels represent the consensus of all market participants.
Any investment in the share market is an investment in a company. You are buying shares because you believe in the future prospects of a company or you are selling shares because you don’t believe in the future prospects of a company. This view of the future can change, but investors’ current view of the future is baked into the share price.
Imagine that an investor buys stock in Tesla because of a conversation with a mate at a BBQ. In this case the investor might only have an expectation that the share price is going to continue to go up without a whole lot of rationale to back this view. It might be because it went up in the past so it will continue to go up in the future. It might be because the investor is concerned about climate change and thinks investing in Tesla will make a difference. It doesn’t really matter. What matters is that the investor thinks the share price will go up.
If this expectation isn’t met, the owner of the share could turn into a seller.
Take a more informed investor. This investor has built a discounted cash flow model. She has estimated out future cash flows that Tesla will earn. Baked into this model are a lot of assumptions. How many cars they will sell, how much they will have to invest in new factories, how much the raw materials will cost for cars and batteries – all of the detail needed to go into this model. So this investor also has expectations of the future that is driving her decision making process. If this model tells the investor Tesla is a good opportunity in the future than it is likely she will buy the stock.
We’ve looked at investors on opposite ends of the sophistication spectrum but in both cases future expectations are baked into the decision-making process of both these investors.
Future expectations are the driving force in all the buyers and sellers of Tesla on a daily basis. The equilibrium of all these opinions about the future for the company is represented in the share price on any given day. Long-term sophisticated investors, short-term first-time traders – everyone.
Share prices do not exist in a vacuum. How it will perform in the future is not just based on how the company does. It is how the company does in comparison to all the expectations of investors out there. We covered expectations in a classic episode of Investing Compass.
Mark has written an article on ‘How to Earn 1.7% more than the average investor’. This article explored the inherent ‘FOMO’ (fear of missing out) that investors have that lead to poor decisions.
These poor decisions stem from chasing returns – trying to jump on appreciated assets where expectations are sky high, and there is a higher chance that they won’t be met. When expectations are high, the consequences can be profound. Here is an excerpt from the article where Mark speaks about the intersection of chasing performance and assets with expectations baked into the price.
"We invest based on our anticipation of the future. Expectations of the future are therefore baked into security prices. If investors have high expectations for the future prospects of a company the shares will trade at a higher valuation. That isn’t necessarily a bad thing – as long as those expectations are met.
For example, when the economy is strong and growing it is good for company earnings. But shares often rally significantly prior to the economy turning. This can create cognitive dissonance for investors. The economic environment experienced on a day to day basis is very different than the performance of the stock market which is already looking down the road to an economic recovery. This is very challenging for investors.
In webinars I often use the global financial crisis as an example. The American stock market rally began ~6 months before unemployment peaked in the US. And it is important to remember that it would have required clairvoyance at the time to know this actually represented the peak. Investors who waited for clear signs of an improving economy missed out on significant gains that grew into one of the greatest bull markets in history.
In retrospect it seemed obvious that it was a good time to invest. Market commentators will look back to history and say that shares were cheap and point out the rally that followed as justification for their view that it was an obvious time to invest. We take comfort in the logic of this argument and assume that we would have acted rationally and purchased shares at the bottom of the market.
But at the time shares were not cheap because earnings had fallen in response to the economic crisis. What made them cheap in retrospect was the economic revival and the resulting earnings recovery. And there are countless examples when the market has rallied on hopes of a recovery which didn’t come to fruition. The classic bear market rally."
The larger point is that timing the market is hard. Expectations are baked into prices which means that once there is more clarity on the certainty of an outcome it is often too late. Timing the market means anticipating future events before other investors. It also means getting the call right. That can be a lonely and intellectually challenging exercise. Because everyone else is doing and saying the opposite. It is hard to go against the crowd.
The timing decisions that cause the gap between investment returns and investor returns come from chasing asset classes, sectors and individual funds and ETFs after their periods of outperformance. Investors believe they are onto a sure thing because the investment narrative is compelling and the feedback loop of recent outperformance reinforces this optimism. I’ve written about this in response to the ongoing Lithium narrative.
Chasing performance is not simply looking at what performed best and investing in it. It is operating under the illusion that investment success stems from being nimble and responding to what seem like can’t miss opportunities.