Psychology plays a dominant and self-fulfilling role in successful investing and economic growth: if people think things will be positive in the future, they will spend and invest; if they turn pessimistic regarding the future, refusing to spend and go into their shells, growth will slow down. This is what economists call “animal spirits.”
The Idea of Expectations Investing
In behavioral investing, the key is to explicitly distinguish between fundamentals (the value of the business based on future financial results) and expectations, which is the market price and what is implied about those results.
The idea of expectations investing starts with asset price and then reverse engineers the expectations consistent with that price. The goal of such concept is to have a sense of what asset price implies about future financial results, e.g., sales growth, operating profit margins, capital intensity, and returns on incremental capital. The process of expectations investing assesses how the fundamental results are likely to be:
- Magnitude – to get a sense about expected cash flows. In this phase, a few assumptions need to be made: sales growth, operating profit margin, working capital investment, fixed capital investment, and tax rate (if applicable).
- Risk – risk is typically captured in the opportunity cost of capital, which can be broken down into two components: cost of debt and cost of equity. Relatively, the cost of debt is relatively straightforward which is just the rate a company would pay on a new issuance of debt, while the cost of equity is more difficult to estimate since the cost is implicit. CAPM framework works but there are inherent flaws with the model (please see my arguments in the previous articles).
- Timing of cash flows – the period of excess returns: an investment that generates a return in excess of the cost of capital is great but that a return equals to the cost of capital does not mean the business will stop growing – it simply indicates that the company is not generating incremental value, such as the “perpetuity” model.
Successful investing distinguishes fundamentals from expectation. Fundamental analysis gains an insight in the business’ growth, return on investment, and sustainable competitive advantage; expectations study necessitates what the current asset price implies about future results.
The Role of Intuition in Forecasting
Macro-economic forecasts typically involve a model component, the replicable component, as well as intuition, the non-replicable component. The problem with a simple and straightforward analysis is that it is based on data, and data exists in the present or past. People who have experienced surprising outcomes in various situations (good or bad) are less likely to take risks in the future. In another word, it is not about investors win or lose, but whether or not the outcome is expected.
Investors are prone to errors in judgment when appraising risk:
- The availability heuristic
- The affect heuristic
- The illusion of control
- The illusion of uniqueness
- Loss aversion
Furthermore, investors tend to experience decision biases when thinking about these financial results:
- Anchoring – investors tend to be more influenced by numbers, even invalid ones, and do not adjust ways from them
- Framing – how a situation is presented affects investing decision
- Availability heuristic – vivid, easily imagined but uncommon events are highly weighed in the brains
- Conformation bias –initial investing decisions become self-fulfilling prophecies
- Commitment escalation – making decisions and committing resources does not necessarily guarantee a reward; it may produce a loss
- Hindsight bias – once investors know something, they do not remember when they did not know it
Then for us investment consultants, how can we better serve our clients who are carrying mismatching expectations? In my opinion the following steps that may also help:
- Proactively inquire about clients’ financial health, return expectation and level of risk tolerance
- Summarize meetings and to-do items for the clients to follow up on
- Hold regular meetings at times optimal for the clients
- Consider involving fund managers
- Modify traditional assumptions and techniques when appropriate to tailor planning to clients’ unique circumstances