**Behavioral finance FAQ / Glossary (Expectation)**

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Dates of related message(s)in theBehavioral-Finance group(*):

Year/month, d: developed/ discussed,

i: incidental

(mathematical) Expectancy /

Expectation (of value)See (rational, mimetic)

expectation, (fair) value,

observer effect

Divinatory powers? Or just a calculation?

General definition (expectation) :An expectation is a

beliefabout what will happen in the near or far future.This belief can be

either personal or common to a whole group.

more or less strong (degree of certainty).

either rational or irrational and be based on:

* Wisdom / educated guess : observation, knowledge , reasoning,

deduction, imagination,* Or feelings / emotions (hope, fear, love, aversion...) and wishes

* Or (automaticity) reflexes, habits, tenets, not to forget mimicry.

As will be seen below, the

economic expectations include something more, that imply mathematical probabilities.

precise

Whatever their scientific aspects, those specific expectations are influenced by

the above mentionned human factors (see the "probability" and "numeracy bias"

articles).

Economic definition

( mathematical expectation):

Adding two and two in the future.

is already worth something now

The mathematical expectancy / expectation of value,

or in simpler words theexpected value(of an investment /

an asset), is calculated by :

1)Taking into accountvarious scenariosand the

probabilityof every one.(positive ones, such as

2) Discounting, for each scenario,

the expected cash flows chain

sales or gains, negative ones such as costs or losses

3)Using for this discount calculation anadequate return rate

that takes into account the cost of money (interest rate) and

the various market risks.

4)Applying to each end result its probability mentioned above(the sum will give the weighed average of those values).

That expected value of an asset is often considered as its

fair value(see value).

First step: expected cash flows and their weights

The weights of all futures

Scenario

number

Result of

each scenario

Scenario

probability

Mathematical expectationbefore discounting

# 1

+ 100

50 %

+ 100 x 0.5 =

+ 50# 2

+ 20020 %

+ 200 x 0.2 =

+ 40# 3

- 80

30 %

- 80 x 0.3 =

- 24

Sum = expected value(not discounted)

50 + 40 - 24 =

+ 66

Discounted value ("present value")

= Time is money,

therefore time has to be accounted for.

In the table above the results are not discounted.

We have now to discount them to find their "present values".

But what is "discounting"?

It is using, as "discount rate", areturn rate that includes:

A riskless return rate, i.e. the interest rate of

a 10 year sovereign bonds,

And a risk premium(see that word) (*)This gives a

total "discount rate"of:

For example 5%

For example 6%

5% + 6% = 11%In other words the investor reckon that 1 Euro

invested today would earn 11 cents in a year.Thus the initial amount would become

1.11 EurosIf you divide that amount expected in 1 year by

You find as

"present value"

equal to the initial 1 Euro

1,11

1,11 Euros / 1,11

= 1 EuroIf the result is expected in 3 years time,

it has to be divided by

1.11 x 1.11 x 1,11

= 1.37Thus, to be consistent wit the first table,

A non discounted 66 Euros result (found in the

above table) has a "present value" of (**)

66 / 1.37 = 48

(*) If we use, not a general risk premium, but a "personalized" one

(= relatedtothe investor risk aversion), theexpected valueis

transformed into that investor's"expected utility"(see that

phrase).

(**) This is a simplification, the real calculation

should be

applied toeach scenarioof the above first table

and madeyear by year.

Another reason that makes it

important to calculate a presentis that this gives the decider a full

value for each scenario

information on every possibility.

Thus it can it draw its own conclusions / choices.

This is crucial (see "range estimate aversion" glossary article) as it

is not the job of the analyst / expert to decide for him / her.

The adviser should not behave as the boss, or be considered

as the boss!This social bias (see obedience to experts) happens when the

decider is left no choice as it is given just one answer and

thus does not know all the possibilities.

Expectancy bias / effectSee expectation, (fair) value,

observer effect, Goodhart law

Predicting value first, finding reasons for it later!The expectancy bias / effect (or

observer-expectancy effect) is a form of the

observer effect (see that phrase) applied to finance.

It is the rather common tendency of analysts or investors

to alter unconsciously their assessment of an asset's

fundamentals so thatit fits their own optimistic

or pessimistic expectations

about the asset price.This bias distorts the "expected value" (see expectancy, value) calculation,

making it rosier or darker than it should be.

Dates of related message(s)in theBehavioral-Finance group(*):

Year/month, d: developed/ discussed,

i: incidental

(rational-mimetic) Expectations

00/6i,8i - 01/1i,3i,4i,12i - 02/1i,7i,9i

- 03/10i - 04/8i,9i - 07/2i,3i - 08/2i

+ see anticipation, positive feedback,

cascade,rational, beauty contest,

bubble, rational choice, greater fool,

deception, expected utility,

disappointment + bfdef2

Expectation or imitation?Expectations of futures prices and returns are obviously an important, and tricky,

factor ininvestment decision making.

Rational vs. biased economic expectations.

Logical deduction or whimsical divination?

suppose a rational interpretation of outside

Rational expectations

signals(more or less salient information).The "rational choice" theory (see that phrase) considers common expectations,

at leastin economic and financial matters, asmostly rational.

In other words, that theory states that the price expectations of

the bulk of investors are close tothe best previsions of pricethat can be made using all known information.

equilibriumBut

this is true only to some degree, as:

Attitudes and emotionsplay a part.They can lead to

biased expectations(see optimism /

pessimism, overconfidence / under-confidence, magical

thinking, knowledge illusion, conformity, uncertainty

aversion, etc....).

Also, investors

privilege often, as signals, not only

economic fundamentals, but also

the

recent market price movesTherefore, expectations are sometimes hard to distinguish

from mimicry and their rationality might be limited.Another thing is that expectations can

orientatefuture realities

(see reflexivity, self-fulfilling prophecy, but also greater fool delusion).

Market signals and expectation paradoxes

Surprise, surprise, the same phenomenon

can bringoppositeexpectations.

Information (see that word) and signals, and among them market price signals

(rises or falls), are subject to interpretations by players, which could cause

paradoxical market behaviors.In an asset market, a strong price rise (or fall) can be seen as opposed

signals depending on the investor, the period, the situation:

A strong

priceriseA strong

pricefall

can be seen by investors as a signal that

Those assets become

expensive.

This gives anincentive to sell.

Those assets become

cheap.

It gives anincentive to buy.

or, on the contrary, as a signal that

The future is

favorablefor those

assets. It gives an incentive tobuy,and breeds another rise.

The future is

unfavorablefor

those assets. It gives an incentive

tosell,and breeds another fall.This might even lead to a "circular" expectation, as traders might

buy or sell just because theyexpect that others will think and do the.

same=> They feed a momentum in the direction of those purported opinions

(see "beauty contest").This can turn to be the "greater fool delusion" for those who follow it for

too long.

Can expectations be created?

And what about deception?

Expectations under influence.

Market expectations might be

* either strictly personal

(imitating what other* or driven by mimicrywith the group

investors think and do).

In some cases, outside authorities or sources use their crediblity to try

voluntarily toorientate public expectations.For example, a central bank sometimes tries to influence it by giving hints

about its future strategy by sending various rhetorical signals.

As there is a tendency towards biased expectations, manipulators can

try tobait people into some forms of expectation, byskewing, or by

informationriggingdirectly market prices with artificial buying

or selling that sendfalse signalsto investors (see deception).

Reaction to outcomes

From weak satisfaction to strong dissatisfaction.Some studies have shown that people tend to,

in an emotionall reaction:

When result are

above their expectations,take this as grantedand

are not specially happy.But when they are

below expectations, feel a strongdisappointment.This asymmetry is one of the aspects of the

prospect theory(see that phrase).This might explain why negative earnings surprises (see surprise), even when

the difference between the announcement and the expectation is slight, have

such bad impacts on market prices.

Expected returnSee also expected value

The expected return is the algebraic sum of the

expected gains and losses(actually their weighed average).

multiplied by their probabilitiesThe formula is similar to the one used in the (mathematical) expectancy of

value (see above the related article) except that in this case it is the return

rate that is the unknown value in the equation.

Expected utility

See the utility article

for a full definitionThe expected utility is the expected value

modulated by a personalrelated to the player's preferences and notably to its risk attitude.

coefficient

Expected valueSee (mathematical)

expectancy of value

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This page last update: 26/08/15

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