The investment fallacy of good or bad

Posted by Jacob Radke
July 21, 2023

Investments: Better or Worse Than Expected

Investments are never judged on good or bad outcomes, but rather on better or worse outcomes than expected.

Integral to how the market performs is how market participants think. You can never fully predict movements in pricing without understanding why an asset is already priced the way it is.

Coinbase is up almost 100% after the SEC alleged that Coinbase was operating as an unregistered exchange, broker, and clearing agency, and that it failed to register the offer and sale of its staking-as-a-service program. Bad news, yes and it still is bad news, but things have turned out better than expected since then and that is why you see the performance, better than expected.

Carvana stock is up more than 1000% this year on news that it may not be bankrupt, or at least not as bankrupt as people thought.

In both of these cases, though, the overall worse than expected news in the last 3 years has given them over 80% drawdowns from highs, things have just modestly turned around from the basic expectation of bankruptcy.

Practical Cases

Charles Schwab after earnings Q2 2023

Charles Schwab just reported a near 40% drop in earnings on Tuesday, yet the stock was up over 12% during the trading day.

The reason was because everyone knew it was going to be bad, but everyone thought it was going to be worse. So when the results came out and they were better than expected, investors started buying it back up to a fair market value.

A speculator would’ve analyzed over the last couple of months whether or not Charles Schwab was in better or worse financial condition that investors thought and came to a conclusion before the actual results came out.

JPMorgan Chase after earnings Q2 2023.

JPMorgan Chase reported a 67% jump in earnings, now that sounds pretty good to me. However, everyone was expecting that because interest rates are 4.5% higher and the bank hasn’t increased it’s savings rates to that level. It makes sense when the principal business is to borrow money from people and lend it out at higher rates, that it makes more money when rates are higher. The stock was only up <1% after it reported. It was around expectations, no better, no worse.

I hope you are catching on. It doesn’t matter how good or bad something is, it only matter how much better or worse it becomes.

Applying the Lens to the Market

When I talk about the market and it’s valuation I am looking through this lens.

What is the market pricing in today that could come out better or worse that expected.

It’s my understanding that the market is pricing in no recession, or at least very mild, a strong labor market and consumer, and lower inflation. Now better or worse. If in 12 months from now we see a recession, the labor market tick up to 5% unemployment, and declining retail sales, it would be totally rational to expect the stock market to fall on worse than expected information.

The risk is that you are wrong about your assumptions in the market currently, or wrong is your expectations around what could happen in terms of better or worse than others are thinking.

So either you are wrong period or you are right or wrong and you just were wrong about what other people had thought and priced into the market.

The longer you hold, the less worrisome those risks become. And it’s because people generally underestimate what can happen over long periods of time and overestimate what can happen in short time frames.

This is why the buy and hold method is so successful and popular, it’s because there is no need to speculate in the short term on what others are thinking and you can know that generally people are going to underestimate the future.

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