Taking Risks and Reaping Rewards

Great Expectations

In the recent Economist, an article outlining the work of Ulrike Malmendier of the University of California at Berkeley and Stefan Nagel of Stanford University showing that under identical market conditions, and controlling for age, people who had experienced lower stock market returns over the course of their lives put a smaller fraction of their money into stocks than people who had lived, on average, in times when stocks had done better.

They attribute that to beliefs being affected by experience. Beliefs after the great depression were jaded and people didn't put money into stocks compared to people in times when the market did better.

I haven't read the study and this is off the cuff, and, although it sounds like a reasonable conclusion, I have to wonder if we could rationally expect or even accept a different result.

Stock prices are based solely on supply and demand. If people expect stocks to rise, they invest, and Voila! stocks go up. If they expect stocks to go down, they sell, and again, Viola! stocks go down. The stock market is nothing if not democratic. Majority rules. More sellers than buyers, prices fall, and vice-versa.

So while one might attribute the reason for the low demand to the expectations of the people, one has to ask what, besides past returns, is causing that expectation? Surely there are experts that wouldn't be taken in by such amateur approach. Value can be established to a reasonable degree and when stocks get cheap, professionals increase their demand. To suggest that a booming economy and subsequent increases in profits wouldn't impact stocks prices due to the expectations of the masses is to ignore the ability of professionals to calculate the NPV of future cash flow to see bargains. Additionally, prior to the advent of the 401K and IRA, most in the market were professionals making it hard to believe that the expectations of the masses were the primary driver.

At the very least, including the dismal economy in the discussion would seem to be a worthy addition here.

What can we learn from this?

Investors, amateur and professional alike, take action based on their expectations for the future. The amateur often looks in the rear view mirror to see what happened in the past and projects it into the future. This is why mutual funds after a good year see massive inflows. They expect the pattern to continue and what they really want is what they can't have which is yesterdays good news.

Professionals on the other hand, know better. They look out the windshield and they often have totally different expectations about the future. They know that the past, while a part of the equation, isn't the primary or sole evidence needed to form a expectation of the future.

The result of this difference is the common occurrence of professionals selling to amateurs at market peaks and buying from them at market bottoms. Their expectations about the future are different and...

Expectations are everything.