2024-02-23: The importance of expectations

There are three reasons the investment management industry cannot consistently produce the desired effects of beating the markets on a large scale (the exceptions exist, though unclear if by skill or luck): the difficulty of predicting the future, the quality of the investment professionals, and accurately determining market expectations (1).
     There is not much to add about forecasting. No one gets it right.
     The professionals are among the best educated, ambitious and intelligent people in any industry, some of them with backgrounds in sciences and fields very far away from finance. To beat the market you need to be smarter than a lot of very smart people. Good luck with that. Add to this mix the fact that information in asset management is generally extremely porous (there are very limited barriers to entry or defensive moats in investing; pretty much everybody knows what everybody else is doing, and successful strategies are copied in no time).
     Market expectations (the expectations of investors with actual money at stake, not the well-known and widely distributed views of analysts, economists and sundry pundits), the third and possibly least analyzed reason for failing to outperform markets, are easy to conceptualize but, like many economic theoretical values, are not observable. Without them we cannot know what the price of an asset represents or, if we aspire to forecast, we have even less of a chance of getting it right. John Maynard Keynes understood this difficulty – and the problems that it encompassed – many decades ago and paraphrased it very well in the context of a beauty contest (2).

Notes:
   (1) I originally wanted to write about the various types of market participants; in a draft I disrespectfully classified most of them as ‘punters.’ A good friend and assiduous reader who saw the draft said that I had too many different types of punters, I was too nasty to all of them, the piece wasn’t funny and it did not teach much. (Nevertheless, if you are curious write to me directly. I still have the draft.)
   (2) “It is not a case of choosing those [faces] that, to the best of one’s judgment, are really the prettiest, nor even those that average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees.” (Keynes, General Theory of Employment, Interest and Money, 1936).

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Another good week for the markets, this time bonds included. Good news appeared to have come from everywhere. The Japanese stock market closed a gap that lasted for 35 years (I remember those days very clearly), and some company quarterly reports pointed to the stratosphere. And, more puzzling for me, this market behavior happened in the context of reduced expectations for lower official rates.   

[Cover Source: https://perfusion.com/long-term-outcomes-favor-heart-surgery-over-stents-and-angioplasty/]