Those are the most important numbers to the market and to investors — but the market wants to know more than what the numbers are today. The market is always looking ahead, and it wants to know what the numbers will be in the FUTURE. You will find THE DIRECTION of the numbers is often more important to the market than the actual numbers.
As I will explain, thinking about the direction of those numbers is where the numbers weave into expectations and where the math weaves into psychology.
Expectations
Stocks are all about expectations. The story and numbers we’ve discussed have expectations built into them. Your frame of mind as an investor has expectations built into it. It takes successfully navigating both to be successful as a stock picker. You must find the company you want to buy, but you must also behave properly after you buy it to have long-term success.
The Direction of Numbers: Predicting the Future
As we discussed, the direction the numbers are moving are as important to the market as the numbers themselves. The direction of the numbers implies some level of expectation or assumption on what the future will look like. Thinking about the direction of things is where story, numbers, expectations, and psychology come together.
“It’s tough to make predictions, especially about the future.” — Yogi Berra
You’re predicting the future when you assume earnings will be the same next year, or higher next year — or anything at all next year.
Stocks tend to follow the direction of company earnings, with heavy influence from the direction of company dividends and the relative value of the company Price to Earnings ratio (PE ratio).
Investors have expectations for the direction of earnings and the direction of dividends and PE ratios. The expectation of the direction of these numbers determines stock price performance. That’s a brain twister, but it’s the truth.
As an example, companies report earnings quarterly. If a company surpasses the expected earnings numbers, but tells investors future numbers will be weaker than expected, the stock will likely be punished. That’s because investors found their expectations for the direction of the future numbers was wrong, even though the current number was better than expected.
Important: Be aware of your expectations, the expectations of others, and where these expectations may be right or wrong. To over-simplify, when expectations change, stock prices change.
Recency Bias
When it comes to our expectations for the future, things that have happened more recently have greater influence on our expectations than things that happened long ago. There is a natural tendency for humans to assume life will continue as it has in the recent past. If a stock has been going up and all the news is good, it’s easy to feel like it will keep going up and the news will stay good forever. The same is true when it’s going down and all the news is bad.
Previously, we discussed that as an investor, you should “always be looking around the corner.”
I gave you a list of questions to consider with the point being to think about where you see your company over the long-term so you can set your expectations for the future. This is an example of making sure you understand expectations. What are your expectations of the story?
All the things we know, as well as our expectations regarding those things, are relevant. One change to our expectations for earnings or dividends or PE changes the story.
Know Your Stock
Expectations can make all the difference in a lot of things, right? This isn’t a stock picking thing. This is a life thing. If you’re too pumped up for something, it can be a letdown. If you aren’t expecting much, you might be pleasantly surprised.
It’s similar to “perspective.” Seeing something from a different perspective can certainly change our behavior. Looking from a different angle can give an entirely different point of view.
It is no different in the stock market. Every now and then, investors get a little too pumped up, and a stock goes up too much. It hurts when you find you were too optimistic as well and bought it right before it came back to reality.
Sometimes investors don’t expect much and are pleasantly surprised. If you expected more than others in the market and bought, it feels good because the stock will go up as expectations change for the better.
The reason the market is always moving is that the expectations are always changing.
Remind yourself what type of business you are buying. Are you buying something new and growing or old and established? It is logical when you’re starting a new business to expect your sales to fluctuate a little more than they will in 12 months or 12 years. You may need to remind yourself of these expectations if the stock price goes the wrong way for a while.
Originally published at https://www.teachingkidstobuystocks.com/ on February 4, 2020.
