The Essential Role of Expectations in Investing

The Essential Role of Expectations in Investing

By Jack Forehand, CFA, CFP® (@practicalquant) —

To make money in the markets, one needs to be an independent thinker who bets against the consensus and is right. – Ray Dalio

I am a big New York Jets fan. So I am used to disappointment. The Jets haven’t appeared in the Super Bowl since 1969, which is the longest drought of any NFL team. Despite this history of losing, I go into every season optimistic.

Like I do every year, last Sunday I started the day feeling good that this season would finally be the one the Jets turn it around. And as happens pretty much every year, I ended the day disappointed as they lost 24-9 to the Ravens.

Bettors in Las Vegas do not share my optimism about the Jets this year. Going into the season, they had the lowest odds to win the Super Bowl of any team. So if you wanted to light your money on fire and bet on them to win it all, you could make a lot of money if you are right. The reason is that the betting market is priced based on expectations, and in the case of the Jets they are very low.

I am also a Yankees fan (at least I root for one winning team). The Yankees had one of the best starts to their season this year in history. They were on pace for one of the top five highest win totals in baseball history. In the half way point of the season expectations were sky high. If you had bet on them to win the World Series at that point, you would have received much less favorable odds than a bet on the Jets to win the Super Bowl. Expectations were much higher for them given their strong results.

In the world of investing, the Jets were the equivalent of a value stock and the Yankees were the equivalent of a growth stock. The Yankees are clearly the better team, but because of expectations, there were potentially not the better bet.

Expectations in Investing

The same principle applies to investing.

One of the ideas that many people don’t understand about investing is that nothing is more important than expectations. The market does a very good job of pricing stocks based on what their businesses are expected to do going forward. So you may feel that certain growth stocks have lofty valuations, but those valuations are high because the market is pricing in their strong future growth potential.

Value stocks are the opposite end of the spectrum. Their businesses are typically not as good as their growth counterparts. They typically have significant problems they are dealing with. And the market prices them accordingly.

Investing in stocks is not about figuring out which stocks trade at high valuations and which trade at low valuations. It is about trying to figure out where the expectations that are priced into a stock are wrong.

We discussed this issue with Michael Mauboussin of Counterpoint Global when he came on our podcast. He sums it up well in a presentation have gave on this topic:

Having been on the sell side for many years and then on the buy side, I can say categorically that the single greatest error I have observed among investment professionals is the failure to distinguish between knowledge of a company’s fundamentals and the expectations implied by the company’s stock price. If the fundamentals are good, investors want to buy the stock. If the fundamentals are bad, investors want to sell the stock. They do not, however, fully consider the expectations built into the price of the stock.

In other words, the current expectations of the market are already priced into every stock. Investors tend to think stocks with good fundamentals are better than ones with bad fundamentals, but that isn’t the case, because the market’s opinion of those fundamentals is already reflected in the current stock price.  The only way to make money is to have a differing view from that (which is the easy part) and to be correct about it (which is the hard part).

That is the reason that value investing works over time. Value stocks tend to all have significant problems in their businesses. That is why they are cheap. But the market tends to systematically overestimate those problems, which provides an opportunity for patient investors who can wait around until the market realizes that. Value investors are taking a non-consensus view and are hoping that time will prove them correct. But this is a bet that value investors are making on average. That means that there will be some stocks that exceed expectations in the value basket, some where expectations are about right, and some that fall below them (these are often called value traps). This makes individual stock picking in the value space more difficult.

Growth investing is more challenging on average for the same reason. The market tends to overestimate the future promise of growth companies, which leads to a cycle of rising expectations that companies eventually have difficulty meeting. There are obviously exceptions to this and companies like Amazon and Google can continue to beat expectations for a very long time, but a basket of growth companies will eventually struggle due to this problem.

We are seeing one of the best examples of this in history right now. By early 2021, growth stock expectations were potentially as high as they had ever been. The bar in terms of the results they would have to produce to meet those expectations was well beyond what was even possible in the most optimistic scenario. When the market recognized that reality, they were punished severely.

The Reality of the Market

But regardless of whether you in invest in value or growth stocks, making money in the market is a constant game of trying to figure out what expectations are, where they are wrong, and how to profit from it. The first part is the easy part. The second two are much more difficult. As human beings, we will always be overconfident about our ability to do this and we will often be disappointed in the results.

So I will likely continue to think that expectations are wrong when it comes to the Jets, even if that results in continued annual disappointment. But when it comes to investing, we all need to recognize that the game of trying to outsmart the expectations embedded in market prices is a very difficult one, and one that most investors won’t win.

Jack Forehand is Co-Founder and President at Validea Capital. He is also a partner at and co-authored “The Guru Investor: How to Beat the Market Using History’s Best Investment Strategies”. Jack holds the Chartered Financial Analyst designation from the CFA Institute. Follow him on Twitter at @practicalquant.