Behavioral finance FAQ / Glossary (Expectation)

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Dates of related message(s) in the
Behavioral-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 belief about 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
precise
, that imply mathematical probabilities.

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 the expected value (of an investment /
an asset), is calculated by :

1) Taking into account various scenarios and the

     probability of every one.
2) Discounting, for each scenario,
    the expected cash flows chain
(positive ones, such as
   
sales or gains, negative ones such as costs or losses  

3) Using for this discount calculation an adequate 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 expectation

before discounting

# 1

+ 100

50 %

+ 100 x 0.5 =

+ 50

# 2

+ 200

20 %

+ 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", a return 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 Euros

If 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 Euro

If the result is expected in 3 years time,

it has to be divided by

1.11 x 1.11 x 1,11

= 1.37

Thus, 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

       (= related to the investor risk aversion), the expected value is
       transformed into that investor's
"expected utility" (see that
       phrase).

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

applied to each scenario of the above first table
and made year by year.

Another reason that makes it important to calculate a present
value for each scenario
is that this gives the decider a full

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 / effect

See 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 that it 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 the
Behavioral-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 in investment decision making.

Rational vs. biased economic expectations.

Logical deduction or whimsical divination?


Rational expectations
suppose a rational interpretation of outside
signals (more or less salient information).

The "rational choice" theory (see that phrase) considers common expectations,
at least in economic and financial matters, as mostly rational.

In other words, that theory states that the price expectations of
the bulk of investors are close to the best previsions of price
equilibrium
that can be made using all known information.

But this is true only to some degree, as:

Attitudes and emotions play 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 moves

Therefore, expectations are sometimes hard to distinguish
from mimicry and their rationality might be limited.

Another thing is that expectations can orientate future realities
(see reflexivity, self-fulfilling prophecy, but also greater fool delusion).

Market signals and expectation paradoxes

Surprise, surprise, the same phenomenon
can bring opposite expectations.


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 price rise 

A strong price fall 

can be seen by investors as a signal that

Those assets become expensive.
This gives an incentive to sell.

Those assets become cheap.
It gives an incentive to buy.

or, on the contrary, as a signal that

The future is favorable for those
assets.
It gives an incentive to
buy, and breeds another rise.

The future is unfavorable for
those assets. It gives an incentive
to sell, and breeds another fall.

This might even lead to a "circular" expectation, as traders might
buy or sell just because
they expect 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

* or driven by mimicry with the group (imitating what other
   investors think and do).


In some cases, outside authorities or sources use their crediblity to try
voluntarily to orientate 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 to bait people into some forms of expectation, by skewing
information
, or by rigging directly market prices with artificial buying
or selling that send false signals to 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 granted and
   are not specially happy.

But when they are below expectations, feel a strong disappointment.

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 return

See also expected value

The expected return is the algebraic sum of the expected gains and losses
multiplied by their probabilities
(actually their weighed average).

The 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 definition

The expected utility is the expected value modulated by a personal
coefficient
related to the player's preferences and notably to its risk attitude.

Expected value

See (mathematical)
expectancy of value

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This page last update: 26/08/15  

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