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Expectations, rationality, investment

Why do expectations matter so much? Because predicting the future has to be really precise to serve as a reliable basis for building a new plant or otherwise undertaking "I" investment. The following is from an online discussion forum in which someone claims to have "the" value for a company, or rather the publicly traded shares in it.

... Always be skeptical! ...

A wise man once said: In theory, there's no difference between theory and practice; in practice, there is.
It's true, the fair value of a company is based on how much cash it can generate over its lifetime. But it's impossible to even roughly estimate this cash generation. The discount rate is also difficult to estimate, and somewhat subjective.
If you're off by even 1% on any of your assumptions, your fair value estimate can be off by as much as 50+%, depending on how far out your estimate is.
My advice: Beware of delusional Tesla bulls bearing discounted cash flow models.

09 Nov 2017, 11:59 AM
Boris Marjanovic, [Seeking Alpha] Marketplace Contributor

The bottom line: you can use formal spreadsheet analysis to highlight assumptions, but in the end the yes/go is based on the expectations of senior management for which scenario is likely, and which (money-losing) scenarios are unlikely. Because such managers read the same publications and interact with each other and give interviews, investment "I" in our macroeconomic sense (and investment in the little "i" stock market sense) reflects social behavior and correlates across firms and individuals. Always be skeptical!

21 thoughts on “Expectations, rationality, investment

  1. yuy20

    Even though people technically understand the influence of unpredictability in their forecasts, they are also prone to rationalization when things go right or wrong. It is easy to look back on a good year and try to base future predictions on past examples; however, we also tend to focus on past details that support our reasoning. Since the past is the only good source we have for the future, one solution is to always consider possible risks within our models and not be afraid to predict the chance of sudden money-losing scenarios, even if they seem unlikely.

    1. murrayc20

      I agree. Rationalization is a huge issue in investing. People tend to rationalize their investments as to reassure themselves that the investment is beneficial; as you said, our desire to invest in a certain company etc., makes us look only at the good aspects of that investment, furthering our determination to act.

  2. williamse19

    I certainly agree that expectations can be dangerous when making investments. However, not all expectations are negative. Some things can be predicted within reason. If we had no trust in expectations, we wouldn't have an economy at all! When you purchase something like a house, a bond, a car or even a textbook, there is an expectation that in the future that purchase will bring utility. In this way, some investment decisions can draw on small expectations that work to the best of our abilities. But these can only go so far. It is always good to remember with high reward comes high risk and a healthy dose of skepticism is always a safe bet.

  3. mcconnellm20

    I think expectations are an important part of investment. Before people make an important decision about investing their money, they are going to consider what they expect is going to happen in the future to see if it is worth it to invest. One can never know whether his or her expectation is going to be right or wrong in the end, but it is nevertheless important to consider what could happen. With that being said, you have to be skeptical about what you expect to happen. There is always going to be a chance that what you predicted will happen does not actually happen.

  4. gutierrezcuadras20

    I can see why being skeptical proves to be valuable tool in investment. At the end of the day, firms want to make a profit and at all times will try to avoid investing in projects they know will not return a profit. As mentioned, the senior partner will give the final yes or no on the project based on expectations. If they believe a particular sector will thrive, then they will be more inclined to invest in a project in that sector. The opposite proves true too. If they believe that sector will take a hit (such as the housing market) then they will be less inclined to invest in the housing market as houses will be seen as losing value in the future. The impact of expectations reflects a psychological and behavioral aspect seen in investment and therefore in macroeconomic analysis.

  5. perelk20

    Skepticism often times seems like the best option when it comes to market predicability and I can see why. Someone has to take responsibility for potentially risky decisions that go wrong. Skepticism relieves managers of these responsibilities. On the other hand, I would like to offer that this skepticism and hubris, perhaps can also destroy that same company. Take Blockbuster for example, failure to invest in future market needs left them behind other emerging companies. I would argue that the only way to progress the company is to make risky investments, to heed skepticism occasionally, but to understand investment risks need to be taken in order to move your company up the financial ladder.

  6. Chris Vogel

    Expectations matter a lot because it is the source of the “gut feeling” that drive decisions of senior management. Expectations of the future macroeconomy and specific business profits ultimately drive the decision behind business investment (I). Since business investment tends to provide relatively good insight into the future of the economy (increase in I GDP increases, and vice versa), these “gut feelings” can, therefore, help steer the economy in a positive or negative direction. A mistake in “gut feelings” can cause a bubble as was the case in 2007. In this case, expectations about the future were incredibly positive, and therefore, lead to subprime loans and failure to pay these loans. Since the gut feeling of senior management is highly prone to things such as a super bowl effect, it can be very dangerous and sometimes inflated. Ultimately, expectations are necessary in decision making, but aren’t necessarily accurate.

  7. murrayc20

    Being skeptical is important when making investments because you do not want to lose money on a poor investment.
    Yet, every investment has a chance to fail, so if your skeptical on those chances, it would be impossible to ever make an investment. If people contined to be super skeptical over every investment, we'd have no economy!
    So yes, skepticism is important but too much skepticism would do more harm than good.

  8. laniere20

    Even though predictions may be incorrect, people want a prediction to base their plans on always. Without any prediction, investment may be seen unsafe or spontaneous, and therefore on would likely choose not to invest without being able to look at any predictions. This means that prediction are an important part of a company reports because they encourage investment, which can increase GDP due to the feedback effect of our macroeconomic economy.

  9. Ellie Bradach

    It is very important to be skeptical. Every prediction cannot come true especially when they are financial predictions. There are too many variables in the market to perfectly estimate how investments will play out. I would disagree with the presumption that money-losing scenarios are always thought by senior management to be unlikely. Of course sometimes, management will take risks and following in the money making scenario is easier, but I think that management will a lot of the time not take risks because of the predictions. The management pays for the predictions so hopefully they use them.

  10. liur20

    When we are considering the topics of investments, there are two things that matter the most: expectations and interest rates. People invest based on their expectations. However, despite how subjective expectations may sound like, it is still based on past records of whatever they are investing. Though predicting the future is hard, it is still possible for us to make an educated guess based on things that happened past. From my perspective, the reason why expectation matter in investment is because usually when someone's expectation is wrong, an entire group's expectation will also be wrong and could lead to catastrophic investment results.

  11. Julia Moody

    I do think that it's impossible to completely accurately predict how investments will turn out, or "see into the future", as the Dilbert cartoon says, but it is possible to invest wisely using one's current knowledge of the market and predicting what will happen in the future to real GDP. However, it definitely is important to be skeptical of headlines businesses put out about their sales and expected future revenues. To evaluate whether or not one should invest in a certain business, one should analyze the earnings reports and P/E ratios of the company and see if the company has been getting more successful over the last few years. It is also important to look at debt when computing the valuation of a company and see how much savings they keep year to year.

  12. bashamc20

    When it comes to investment within a given economy, expectations matter a lot. For one, it is a direct factor in the level of consumption and investment by individuals. When consumers and investors are confident in the performance of the economy, they often believe what has previously happened will continue to happen. I would highly recommend Dr. Thaler's writings on the matter to those who have not read into behavioral economics. Consumer confidence isn't always intelligent strategy, however. Just because the economy is doing well at a given time doesn't mean it will continue to do so. For this reason, we should not rely too heavily on feelings and expectations. Nevertheless, there are many times in which expectations and predictions are beneficial and important. With proper research and data, one can often more accurately gauge the movements of the economy. While its unpredictability is certain, statistically intelligent moves are still calculable.

  13. Kaitlyn Fitzsimmons

    This realty that expectations aren’t guaranteed represent how risk isn't fundamentally inherent in investing. It’s rare that low risk investments yield high return. The possibility of losses, which may be expressed in uncertain expectations, indicate a possibility for reward.

  14. the prof

    Plans are necessarily built upon expectations. How those expectations are formed is thus critical – is it looking at what others are doing and doing the same? Herd behavior can lead you over a cliff. Good business planning for major projects will of course use history and compare multiple scenarios. Things never turn out as planned.
    For macroeconomics, recognizing herd behavior is crucial. Expectations can and do change quickly. As a result investment is volatile, more volatile than ought to be the case given changes in "fundamentals."
    Companies may not be able to diversify: if you're an auto company, you're subject to changes in overall sales. But you can benefit or suffer on the basis of design choices made by competitors. If they have a "hit" then your sales suffer, and vice-versa. Everyone tries to design a new model to sell well. Consumers are fickle.
    The macroeconomy can't diversify. If businesses don't invest, then – remember the multiplier! – the economy will suffer. That's hard to spot until some months after behavior changed. Ideally you'd then turn on the fiscal policy tap to offset that. However it's hard to turn fiscal policy on (or off). Leads and lags make it a very awkward tool, you will often end up making things worse, doing too much or too little, and almost always doing it too late.

    1. lentza20

      If the macroeconomy cannot diversify, then how would it ever be able to reliably grow? Additionally, I understand that it is impossible to see the future and to accurately predict what the economy will do and where it will go. However, if the government knows this, why has there never been a push for a faster way to enact financial policy change? Wouldn't it make more sense for the government to not waste time trying to predict what will happen, but instead be better prepared to react to what does happen?

    2. Juliana Kerper

      Why can't the macroeconomy diversify exactly? It makes sense that certain companies are unable to adapt to overall sales, like the auto company. But if other sectors of business (in as many countries as possible were required to diversify their investments by a certain amount, perhaps by some international agreement, and are able to respond quickly to changes in sales, why wouldn't that be the macroeconomy managing to diversify itself, if only a little? In addition to this, do we consider interest rates, which are predictable for things such as the housing market and even car sales, part of business expectations?

  15. richardsonw20

    Skepticism is necessary for success in the business and investment worlds. As professor has said, herd behavior can lead you off of a cliff. If we are all analyzing the same data and using the same information to make business and investment decisions, then how is this "herd behavior" avoidable? I believe that the herd behavior is avoided when we look at the same information as others through a different lens. Question what effects this information may have on other factors in the economy rather than just one singular aspect of the information.

  16. hermana20

    In the realm of personal investment and investment portfolios, expectations take on an increased importance as personal, market, and stock expectations change. This change of expectations makes investment very volatile and shaky because one minute the market may be overly optimistic and this optimism spreads like a virus leading people to make risky investments, or the market is overly pessimistic and this pessimism spreads like a plague and people stop investing which stunts growth. In the personal realm, with our portfolios, expectations change even quicker. If a stock we invest in increases by 50% in one year should we sell? Maybe, but now our expectations for how that stock will perform have changed, leading us to reconsider whether we will sell it, and how well it will do in the future. In this sense, personal investment is not about predicting the market, but is about expectations as to how one's portfolio will play out against some standard benchmark.

  17. johnsonj20

    Going off of Professor Smitka's statements that "Everyone tries to design a new model to sell well" and "Consumers are fickle," product differentiation should play a large role in driving expectations for growth and potential investment. For companies to stay afloat or have a chance at growing, they need to either adapt to changes in their sector or introduce changes. Innovation is necessary for growth because labor and capital face diminishing returns. Perhaps a manufacturing company invests in new equipment that they expect to produce more efficiently and save costs per unit of production. Promising innovations like such should trigger business investment and spur economic growth via the multiplier effect. Therefore, to encourage investment and innovation, the government should prioritize subsidizing infrastructure, R&D, and education, as well as protecting intellectual property rights by way of patents (the book discusses these tools on pages 260-261).

  18. hartigank20

    Being skeptical is an important part of investment since the future is so unpredictable. Businesses must be wise about their investment decisions and formulate different plans in case their decisions don’t do well in the future. Businesses make predications and expectations about the future of an investment, but they can never be exactly right due to uncertainty of the future. This is why it is important to diversify investments because it is unlikely that all aspects of investment will fail all at once.


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