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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!


42 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.

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    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.

      Reply
  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.

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  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.

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  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.

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  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.

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  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.

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  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.

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  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.

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  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.

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  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.

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  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.

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    1. denatalec20

      I agree, Julia. When assessing a potential investment, we must look at a variety of valuation methods in order to predict the company's potential for success. For example, when looking at potential stock options, the current value of a share tells us little about the value of our investment. Cash flows, and strong business fundamentals tell us much more about a potential for success, than do predicted revenues or expected sales.

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  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.

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  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.

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  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.

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    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?

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      1. yuy20

        The factors that slow down financial policy change often depend on political systems and the deliberation of politicians. It's unfortunate that economics relies so much on political reasoning, but there will always be politicians who want to make the best decision or have political alignments that prevent successful collaboration. I agree with the point that the government should not focus so much on prediction; I think people get caught up with the idea that they are better protected when they think they know what is coming.

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    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?

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  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.

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  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.

    https://money.usnews.com/money/blogs/the-smarter-mutual-fund-investor/2012/01/25/investing-its-about-expectations

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  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).

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  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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    1. patelp20

      I think that skepticism is a part of expectations in our macroeconomic model. I think that many of my peers are placing too much emphasis on the role of skepticism in the economy because it is only one part of what drives expectations. Expectations are also driven by past transactions, macroeconomic trends, and the signals that are sent out by the Federal Reserve. While yes it is important for companies to remain skeptical, I think that theres no reason to delve that out. Corporations are inherently skeptical when it comes to transactions, yet that still does not save the economy from crashes.

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  19. mitchelld20

    Obviously one should always be skeptical when it comes to investing money or spending money on anything that has some sort of risk. It is helpful to have some sort of insight to how the money invested might return, but truthfully no one ever knows anything for sure when it comes to that. Being skeptical at least makes you understand the risks and the rewards of the situation as opposed to just knowing what kind of rewards the investment could bring. Knowing the risks and comparing them to the rewards might make you reconsider the investment that you at one point thought was a sure fire bet. So, I do believe it is imperative to be skeptical.

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  20. litvaka20

    Expectations are central to the decision making that goes into undertaking investment. As stated, it is important to be skeptical because many of these decisions are based on the expectations of a few senior members of a company, and it is likely that many comparable companies tend to get their information from the same sources. The senior management is going to pick a project that they believe will be profitable to the company. However, it is possible to imagine a situation wherein the management has positive expectations about a certain investment, but in reality these investments will not be successful. This is why it is important to be skeptical because sometimes investment projects that are expected to be profitable actually harm the company. If many companies have similar expectations that turn out to be false, it can hurt all companies in that industry. Therefore, it is important to be skeptical when thinking about expectations because they are derived from social behavior rather than reality.

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  21. Nate Abercrombie

    Even though past results are not explicitly indicative of future results, there is much to be said for their usefulness (especially in the short term). Anyone with any sort of knowledge of technological advancements would probably realize that print companies have suffered extraordinarily at the hands of internet-based ones in recent years. By looking at their earnings releases over the past decades, one would not have any expectations for better future results. However, for less established industries (like the electric car market) it is far harder to manage and accurately gauge such expectations. In scenarios like those, it is important to express extreme caution and keep oneself in line with what is realistic.

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  22. the prof

    Along with Richard Thaler, read Robert Shiller, another Nobel laureate. Bubbles in asset markets ought to be a reminder that expectations can feed on each other in a way that amplifies small changes in behavior to have macroeconomic consequences. Of course "investors" are affected by this. (Remember we're in Econ 102 so that means companies building factories and adding to their server farms.)

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  23. Mac

    Future expectations are not something that can be completely reliable. They serve as a good potential prediction but it is very important for companies to prepare for the worse. It is like the saying, "Don't put all your eggs in one basket." I think the top companies in their sectors follow this saying. They expect the future of their investment to come out as their analysts predicted, but they are able to adjust to uncertainty and surprises. Fortune 500 companies adapt and survive to changing expectations when other companies cannot. Placing blame on individuals does not help a company recover from a failed investment. Being skeptical does not necessarily mean not to trust your expected future. It does, however, mean to be prepared for when investments go awry. Also, it is important not to panic when an investment does not immediately produce revenue. A panic in the stock market world can cause a massive upheaval of stock expectations.

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  24. Lukas Campbell

    I believe people generally agree that expectations cannot always be a reliable way to justify certain investments. When you are only working with data from past trends to predict future outcomes, you run the risk of not knowing the exact outcome and its effect on your investment, but it helps to find potential probabilities of various outcomes in the context of your investment. Knowing your possible outcomes and making early preparations for them can be useful for if the investment does not go as predicted; almost every reputable financial institution employs people specifically to recommend ways to prepare for the more likely possibilities of the future. Because no one can predict the future with complete accuracy, not only is it smart to prepare as best as possible for any positive or negative potential outcome, but to diversify your investments such that if one market does not do well in a particular year, you have other investments that can dampen the effects of that loss.

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  25. blaira19

    It is important when investing to take all things into consideration. While expectations can be a good way to predict where a company will go in the next quarter or even beyond, one should consider that their are downturns every once and a while. It is more important for someone to diversify their portfolio than to rely solely on one industry. From factors of competition to natural events like hurricanes or epidemics, the markets are vulnerable to change as we saw recently with hurricane Irma changing the orange juice prices. Or when Zika virus was prevalent, hazmat suits were in high demand sending those companies into the green. It is important to not solely rely on past data as the future can easily change without notice.

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  26. gianakosa20

    Future expectations and preferences cannot be 100% reliable by nature, not just in a macroeconomic sense. Consumer expectations for cars, food, clothes, and even expectations for relationships are unpredictable. This is why we must use caution and be skeptical when investing, especially by diversifying our portfolios to reduce risk.

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  27. mizeo20

    I like how Peter Lynch (former Fidelity Magellan fund manager) put it: a non-institutional investor has an advantage over the big hedge fund managers. The big institutional bankers are ultimately working to keep their jobs, and it has been said "you're never going to get fired if you see losses pitching GE." The average investor goes with the heard, bandwagoning stocks on the front page of the WSJ until inflating their price astronomically. A smart investor doesn't follow the heard, he/she finds an undervalued company that nobody cares about because those are where the largest potential gains are. DCF models are never accurate and as described above the individuals making them are reading the same things as everyone else. Say you are a worker in a steel factory, you know more earlier about the steel industry and where it is going than an institutional investor.

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  28. wilkinsonw20

    Expectations and being skeptical of predictions is a very important aspect of investing. With so many people offering advice and predictions, it can be hard to discern between good and bad advice. I think you stress a very important investing tip, always be skeptical. Even stocks that have been rising for some time may be artificially inflated due to a few's expectations. Before investing it is always important to double check and do some research looking into not only a companies projected growth, but their past as well.

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  29. thaia19

    Expectations are very important in investment. If the public believes real estate prices will rise, demand will increase and the prices will increase. Regardless of what expectations are based on, if enough people have a certain expectation, they will affect the outcome.

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  30. Khang Truong

    What is dangerous is not to use expectations to build investment plans, but rather to forget that expectations are statements of probability. A certain degree of skepticism is warranted, but the notion that we should shun anything that is not certain does more harm than good.

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  31. shenr20

    My first point is, unpredictability is the essence of investment. Because of unpredictability, financial derivatives came out. Futures, options, and other amazing tools were invited. Warren Buffett once said, "the fact that people are full of greed, fear, or folly is predictable. The sequence is not predictable." It was unpredictability that allows investors to make earnings.

    My second point is, there is no perfect prediction. Financial market itself is a dissipative structure. It is a blend of all the factors inside and outside the market. If the predictions proofed to be wrong, it must be some fundamental factors that people didn't notice but very important, and k line won't be missed this kind of factor. Stock market is risky, and the risk is its uncertainty. Because of the uncertainty, no one dare to assure you that the stock will rise or fall to a certain price. The analysis of forecast stock will increase or decrease in the price only serves as a reference.

    My third point is, long-term earnings are stable and predictable for investment. The basic principle of finance is that the benefits and risks are eventually equal. So be wise, and invest.

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  32. motturt20

    The principle of portfolio diversification is hinged on this in a way, seeing as a more diverse umbrella of investments makes assumptions about the economy at large as opposed to any individual company within the group, and is then less prone to unpredictable events that disproportionately effect specific sectors of the economy. The more specific the prediction, the more fallible it may be; Events that dramatically lower the value of a car company, or even that of all car companies, are still much more likely than an event that dramatically and unpredictably lowers the value of a large economy on the whole.

    A question I have would be whether it is reasonable to retain the same skepticism for things that are set on a much larger scale? As an investor, I get the point that I should be skeptical of putting all of my eggs in the Tesla basket, but is it still unreasonable to believe that the tech sector as a whole will grow based on assumptions about general economic and social trends?

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  33. grims20

    I agree that expectations are a dangerous part of investment, but they are also a necessary part. There will never be a surefire way to "win" the stock market and no investment will guarantee a positive return. One should be careful when investing money and attempt to become educated enough to understand when to be skeptical of an expectation. An intelligent investor will understand that much of investing is unstable and relies heavily on social behavior, and will keep a level head/remain rationale when making their decisions, regardless of the expectations provided.

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  34. compolir20

    I think the above cartoon begs the question of why make models at all. The models are still important to gain an overall understanding of whats going on in a situation. Expectations are critical because they provide direction and progress whether right or wrong. Risk is inherent in bot I and i. People must bite the bullet at times if it mens they are trying to win.

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  35. Matthew Marshall

    The comics and analysis above accentuate the number one rule of "I" investment: diversification. To protect against the riskiness of a difficult (if not impossible) to predict stock market, diversifying between stocks, bonds, and other assets builds a wall against risk. As the comic itself suggests, "It's basically just guessing plus math." A higher risk, however, does suggest a higher possible reward, as low risk opportunities very rarely yield high rewards.

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  36. smithg20

    I agree with many others that predictions and expectations for investment are very important for the investment industry. Without these predictions, many individuals would not be able to faithfully invest their money. Although many times these investments may not work out with compete accuracy, it is critical for the stability of the economy that individuals and corporations make diverse investments. It is also interesting to consider the importance of human rationalization when looking back at one's predictions, expectations, and investment results. It is a natural human tendency to rationalize one's past behaviors or thoughts and make poor decisions be due to other unexplainable factors.

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