Expectations and Perceptions
By Mark F. Toledo, CFAOctober 11, 2018
Brad Steinman, Vice President, Dimensional Fund Advisors, recently published an article highlighting the relationship between investors’ expectations, their perceptions of investment results, and their degree of satisfaction.[1] He notes that satisfaction derives from investors perceiving results to be near or greater than expectations. This relationship highlights the importance of expectations and perceptions.
Expectations
Stocks have higher expected returns than safer investments like Treasury bills.
The financial markets reflect investors’ perceived levels of uncertainty about anticipated cash flows for various securities through security prices. Lower prices relative to anticipated cash flows translate into higher expected returns. The higher expected returns for stocks offer investors compensation for assuming greater uncertainty about the level and magnitude of future cash flows relative to bonds and Treasury bills. The higher expected returns represent the equity risk premium.
A positive size, value, and profitability premium.
Market forces set the price of goods and services based on many factors, such as the costs of raw materials, labor, shipping, and advertising, as well as competition and perceived value. Consumers do not need to understand all the inputs to make an informed purchase. They look at the price relative to alternatives to determine if they should purchase the product. The lower the price or the more you get, either in quality or quantity, makes the purchase better.
Similarly, a stock’s price reflects many inputs. Expectations about future profits, different types of risk, and investor preferences are a few examples. Fortunately, you do not need a model to understand these inputs or how they impact market prices. All available information should already be reflected in the price, which tells you something about expected returns. Both consumers and investors want to pay less and receive more.
Expected returns are a function of the price you pay and the cash flows that you presume to receive. Smaller and more profitable companies with lower relative prices have higher expected returns than larger and less profitable entities with higher relative prices. These relationships determine the size, value, and profitability premiums.
The probability of earning a positive premium increases with your time horizon. However, the premium is not guaranteed. Underperformance is possible over any time frame.
Expected premiums are positive, but not guaranteed.
Expected premiums are always positive, but realized premiums may be positive in some years and negative in others. You may even experience a negative premium for several years in a row. Exhibit 1 shows that the equity market outperforms Treasury bills in approximately 65% of the 1-year periods. The probability of small caps outperforming large caps over a 1-year period is 57%.
The probability of earning a positive premium increases with your time horizon. However, the premium is not guaranteed. Underperformance is possible over any time frame. Nobel laureate Paul Samuelson said, “In competitive markets there is a buyer for every seller. If one could be sure that a price will rise, it would have already risen.”
Perception
Perceptions of returns relative to expectations can determine the degree of satisfaction.
If an investor expects a positive value premium over all 10-year time horizons and this premium turns out to be negative, then the investor will be dissatisfied. However, Exhibit 2 shows that this expectation is unrealistic. The size and value premiums have not been positive over all 10-year periods. For example, the 10-year value premium has been negative over the past several years. The probability of a negative value premium over a 10-year time horizon is approximately 24%. Accepting this probability should reduce the dissatisfaction that an investor may feel about the most recent 10-year results.
Lengthy periods of underperformance often produce disappointment because investors obviously prefer higher rather than lower returns. Nonetheless, disappointment should not turn into anger or regret if you know in advance that periods like these will occur and you recognize that you can not predict them.
Instead of regretting periods of underperformance, which might cause you to abandon a well-designed investment plan, try to lean into the outcome. Embrace it by considering that if positive premiums were absolutely certain, even over periods of 10 years or longer, then you should not expect those premiums to materialize going forward. In a well-functioning capital market, competition would drive down expected returns to the levels of other low-risk investments, such as short-term Treasury bills. Risk and return are related.
The Unpredictable Nature of Premiums
The fourth quarter of 2016 demonstrates how realized premiums can change quickly, unpredictably, and with a large magnitude. For the 1-year period ending October 31, 2016, the Russell 1000 index of large cap stocks and the Russell 2000 small cap index returned 4.26% and 4.11% respectively, producing a -0.15% size premium. Shifting the calendar forward by two months to December 31, 2016 produces realized returns of 12.05% for large cap and 21.31% for small cap stocks over the previous year. The 1-year small cap premium rose from -0.15% to +9.26% by merely shifting the start and end dates by two months.
Your satisfaction as an investor depends on your perception of events relative to expectations. Accepting the unpredictable nature of premiums can improve your satisfaction. Proper expectations alongside the appropriate perceptions can help you stay the course and may improve your wealth and well-being.
Mark F. Toledo, CFA is a Partner at Chicago Partners Wealth Advisors. He has been a wealth manager for over 35 years and has helped hundreds of individuals and foundations create better wealth management solutions.
[1] Steinman, Brad, The Happiness Equation, Dimensional Fund Advisors, September 21, 2018
Important Disclosure Information
Past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Chicago Partners Investment Group LLC (“CP”), or any non-investment related content, made reference to directly or indirectly in this commentary will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this commentary serves as the receipt of, or as a substitute for, personalized investment advice from CP. Please remember to contact CP, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services, or if you would like to impose, add, or to modify any reasonable restrictions to our investment advisory services. CP is neither a law firm nor a certified public accounting firm and no portion of the commentary content should be construed as legal or accounting advice. A copy of the CP’s current written disclosure Brochure discussing our advisory services and fees continues to remain available upon request.
October 11, 2018
Brad Steinman, Vice President, Dimensional Fund Advisors, recently published an article highlighting the relationship between investors’ expectations, their perceptions of investment results, and their degree of satisfaction.[1] He notes that satisfaction derives from investors perceiving results to be near or greater than expectations. This relationship highlights the importance of expectations and perceptions.
Expectations
Stocks have higher expected returns than safer investments like Treasury bills.
The financial markets reflect investors’ perceived levels of uncertainty about anticipated cash flows for various securities through security prices. Lower prices relative to anticipated cash flows translate into higher expected returns. The higher expected returns for stocks offer investors compensation for assuming greater uncertainty about the level and magnitude of future cash flows relative to bonds and Treasury bills. The higher expected returns represent the equity risk premium.
A positive size, value, and profitability premium.
Market forces set the price of goods and services based on many factors, such as the costs of raw materials, labor, shipping, and advertising, as well as competition and perceived value. Consumers do not need to understand all the inputs to make an informed purchase. They look at the price relative to alternatives to determine if they should purchase the product. The lower the price or the more you get, either in quality or quantity, makes the purchase better.
Similarly, a stock’s price reflects many inputs. Expectations about future profits, different types of risk, and investor preferences are a few examples. Fortunately, you do not need a model to understand these inputs or how they impact market prices. All available information should already be reflected in the price, which tells you something about expected returns. Both consumers and investors want to pay less and receive more.
Expected returns are a function of the price you pay and the cash flows that you presume to receive. Smaller and more profitable companies with lower relative prices have higher expected returns than larger and less profitable entities with higher relative prices. These relationships determine the size, value, and profitability premiums.
The probability of earning a positive premium increases with your time horizon. However, the premium is not guaranteed. Underperformance is possible over any time frame.
Expected premiums are positive, but not guaranteed.
Expected premiums are always positive, but realized premiums may be positive in some years and negative in others. You may even experience a negative premium for several years in a row. Exhibit 1 shows that the equity market outperforms Treasury bills in approximately 65% of the 1-year periods. The probability of small caps outperforming large caps over a 1-year period is 57%.
The probability of earning a positive premium increases with your time horizon. However, the premium is not guaranteed. Underperformance is possible over any time frame. Nobel laureate Paul Samuelson said, “In competitive markets there is a buyer for every seller. If one could be sure that a price will rise, it would have already risen.”
Perception
Perceptions of returns relative to expectations can determine the degree of satisfaction.
If an investor expects a positive value premium over all 10-year time horizons and this premium turns out to be negative, then the investor will be dissatisfied. However, Exhibit 2 shows that this expectation is unrealistic. The size and value premiums have not been positive over all 10-year periods. For example, the 10-year value premium has been negative over the past several years. The probability of a negative value premium over a 10-year time horizon is approximately 24%. Accepting this probability should reduce the dissatisfaction that an investor may feel about the most recent 10-year results.
Lengthy periods of underperformance often produce disappointment because investors obviously prefer higher rather than lower returns. Nonetheless, disappointment should not turn into anger or regret if you know in advance that periods like these will occur and you recognize that you can not predict them.
Instead of regretting periods of underperformance, which might cause you to abandon a well-designed investment plan, try to lean into the outcome. Embrace it by considering that if positive premiums were absolutely certain, even over periods of 10 years or longer, then you should not expect those premiums to materialize going forward. In a well-functioning capital market, competition would drive down expected returns to the levels of other low-risk investments, such as short-term Treasury bills. Risk and return are related.
The Unpredictable Nature of Premiums
The fourth quarter of 2016 demonstrates how realized premiums can change quickly, unpredictably, and with a large magnitude. For the 1-year period ending October 31, 2016, the Russell 1000 index of large cap stocks and the Russell 2000 small cap index returned 4.26% and 4.11% respectively, producing a -0.15% size premium. Shifting the calendar forward by two months to December 31, 2016 produces realized returns of 12.05% for large cap and 21.31% for small cap stocks over the previous year. The 1-year small cap premium rose from -0.15% to +9.26% by merely shifting the start and end dates by two months.
Your satisfaction as an investor depends on your perception of events relative to expectations. Accepting the unpredictable nature of premiums can improve your satisfaction. Proper expectations alongside the appropriate perceptions can help you stay the course and may improve your wealth and well-being.
Mark F. Toledo, CFA is a Partner at Chicago Partners Wealth Advisors. He has been a wealth manager for over 35 years and has helped hundreds of individuals and foundations create better wealth management solutions.
[1] Steinman, Brad, The Happiness Equation, Dimensional Fund Advisors, September 21, 2018
Important Disclosure Information
Past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Chicago Partners Investment Group LLC (“CP”), or any non-investment related content, made reference to directly or indirectly in this commentary will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this commentary serves as the receipt of, or as a substitute for, personalized investment advice from CP. Please remember to contact CP, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services, or if you would like to impose, add, or to modify any reasonable restrictions to our investment advisory services. CP is neither a law firm nor a certified public accounting firm and no portion of the commentary content should be construed as legal or accounting advice. A copy of the CP’s current written disclosure Brochure discussing our advisory services and fees continues to remain available upon request.