Want to Make Money in Markets? Understand Expectation Errors

Wesley Gray |
Great_Expectations.jpgA new working paper from Gennaili, Ma, and the one-the-only Andrei Shleifer.

Expectations and Investment

Using micro data from Duke University quarterly survey of Chief Financial Officers, we show that corporate investment plans as well as actual investment are well explained by CFOs’ expectations of earnings growth. The information in expectations data is not subsumed by traditional variables, such as Tobin’s Q or discount rates. We also show that errors in CFO expectations of earnings growth are predictable from past earnings and other data, pointing to extrapolative structure of expectations and suggesting that expectations may not be rational. This evidence, like earlier findings in finance, points to the usefulness of data on actual expectations for understanding economic behavior.

The authors find that “high past year profitability is correlated with over-optimism, while low past year profitability is correlated with over-pessimism.”

In other words, to win in a market, one must identify how the market forms expectations, identify how that expectation is systematically flawed, and then exploit it to your advantage.

Alph_Architect_I___6_24.jpg

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

Alph_Architect_II___6_24.jpg

 The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

 

Written by Alpha Architect researcher Jack Vogel. For more market anaylsis from Wesley R. Gray and his team, check out his blog at Alpha Architect here

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

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