Expectations and Outcomes

Expectation is like an invisible driver of a lot of things. Your own decisions, the decisions of the people around you, the time you spend, the effort and resources you expend.

In both life and the markets, Expectations are desires and beliefs morphed together pushing us towards action. After all, if there was no expected reward, why would you risk anything?

Managing expectations

Expectations are a key input in most major decisions, both ex-ante and ex-post. This input in itself is quite subjective. Everyone sets their own expectations and expects from someone based on how well they think they know that someone. I can see two sets of expectations here, both somewhat linked to one another and having equally considerable influence on decisions and the related outcomes.

The first – one that is yours about your own self and an outcome involving yourself, or Internal expectations. These expectations are a function of your self-awareness and perception of your abilities. It is important to calibrate your own expectations, and try to avoid recency biases and ‘resulting’ – basing these expectations on recent successes and failures, and failing to discern between luck and skill.

An old trick in the book, and something I recently realised, is to keep expectations lower than the realistic expected outcomes (and not lowering your bar of course). This ‘margin of safety’ ensures a downside protection – the downside that comes with mental setbacks, something that can hold you back for much longer after an unrealised expected outcome. Managing your own expectations, and calibrating them at both ends of the spectrum, therefore, is key.

The second – one that is someone else’s about you, or External expectations. While your own internal expectations are easier to control, calibrating someone else’s expectations is a tough ask. You might want to believe that you shouldn’t place a lot of value in what that someone else expects of ourselves. But in situations where you’re seeking approval (monetary or other), managing external expectations could critical to ensure you get closer to your expected outcome.

The trick here is somewhat similar. Some push their external expectations up way too much, exposing themselves to a risk of negative surprises. Some would try hard to lowball external expectations constantly, seeking to err on the side of positive surprises. They would not let it get ahead of themselves, reminding their ‘market’ that no one is invincible.

Lower expectations and positive surprises are maybe more valuable in the long run than high expectations and a negative surprise. The key is to manage them the right way at the right time. All this, without lowering your bar.

The expectations game

Investing is largely an expectations game. Expectations are set by the cumulative beliefs of all market participants and the prices you see are a result of those expected future outcomes. Why do you invest in one business and not the other? We are, in a way, optimising for our ‘expected’ returns.

We talk a lot about ‘multiples’ in the markets. Stocks with higher multiples have even higher expectations baked into the price. Here too, ultra-high expectations (in the form of continued growth) can expose us to large downsides by leading us to paying unjustifiable prices for some businesses.

You would observe that stocks that show a surprise earnings beat on low expectations tend to outperform whereas the ones with lofty expectations baked in would tank even at a slightest of misses. The recent carnage in the high-growth names is a perfect example of that.

It is getting ugly out there. Source: @Marlin_Capital

How about return expectations then?

The returns since March 2020 exceeded everyone’s expectations. It was a big positive surprise and probably the shortest recession ever.

Market returns since March 2020. Source: Koyfin

These are not your average year returns. Long-term averages for equities are somewhere between 5-10% depending upon what market you are in. But this recent outcome has changed return expectations quite dramatically.

Long-term return expectations have shifted dramatically. Source: Natixis.com

Can the same principle apply here? Absolutely. Expectations fraught with recency biases can lead you to exit at the worst possible moment. The key is to lower expectations, prepare for a negative surprise while exposing yourself to positive surprises.

You can find many other instances of expectations game being played.

There are two types of management teams in the public markets – the ones that are always trying to show you their grand vision (however unrealistic) and how their company is working towards living it, and the ones that always lowball expectations, accept the road looks tough but set high goals and standards. Both are managing expectations – one’s setting itself for a large downside, the other has all the room he needs for positive surprises.

Even something as simple as inflation is an expectations game. A rise in prices raises expectations of future price rises, leading people to buy more before price rises further, thus raising prices even further. Expected inflation breakevens, an important indicator of real rates in the markets is set via the same game.

You would win and you would lose, but you ought to play this expectations game right. Both in life and in investing.

Until next time,

The Atomic Investor

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