The Independent Market Observer

Investor Expectations Vs. Reality

Posted by Brad McMillan, CFA®, CFP®

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This entry was posted on Feb 17, 2022 3:25:50 PM

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investorsThis will be a quick post, as I am finishing up a Commonwealth conference. As usual, it has been a wonderful chance to see old friends, make new ones, and have a great time in a beautiful place. It was as I expected, given the great people—and even better meeting planners—who make Commonwealth so special. In this case, at least, my expectations were well-founded and have been fully met. But today I want to talk about expectations in a more general way.

Economic Expectations

We are not always as lucky as I have been to see well-founded expectations met, especially in the economic realm. In the past week, I have written about interest rates and valuations, about the taper tantrum and Wordle, and about economic and market risks. All of them implicitly depend on the expectations that investors, as a group, hold and, even more importantly, on the relationship between those expectations and what happens. Expectations are often systematically biased by recent events. Bad news is expected to be followed by more bad news, and good news by more good news. That is how we are wired to think.

Mean Reversion

This works, until it doesn’t. Then we run into mean reversion. One of the foundations of modern statistics, and modern investing, is the notion that periods of unusual performance, bad or good, tend to give way to a stretch of the reverse; that the means (averages) don’t tend to change much over time is another key thing to watch. In fact, that tension—between expectations of continued similar performance and mean reversion that reverses that performance—is the best illustration of how we, as investors, should be evaluating the data. When things are really good, we should be cautious. And when things are really bad? We should at least consider the notion that things will get better.

Eeyore No More?

As regular readers know, I have been known as Eeyore for some time. That came from my stance in 2006-2007, when I was calling for the end of the world. Guilty—and my only defense is that I ended up being right. Since then, starting around 2011, I have been more Tigger than Eeyore. More recently (i.e., at this conference), I have been accused by several people of being all Tigger, all the time. I don’t think that is completely accurate, but it certainly is true I am not doing the full Eeyore. The reason for that is what I see happening and how that compares with expectations.

Right now, there are real risks: around interest rates, on the medical front, growth, international conflict, and many more. At the same time, the perception of those risks—what is expected to happen versus what is likely to happen—seems to me to be out of whack. As long as the fundamentals of the economy remain strong, which they are, those risks seem to be something we can ride out. Is that Tiggerish? Possibly. But when you look at the recovery over the past several years, it also seems to be realistic.

What Investors Should Be Looking For

Lots of things could happen. The plane back tomorrow could crash. The stock market could crash. COVID-19 could come back in a big way. The Fed could hike rates by a full point in March. All of these are possible—but not likely, even as investors seem to be looking at the dark side. Right now, the expectations for the future seem to be tending more toward fear than greed. As an investor, I see that as a good thing. If expectations are low, that raises the odds that reality will outperform. And that, as investors, is what we should be looking for.

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