Irrational Expectations (and 3 things you can do to guard against them)

Expectations are powerful things. They involuntarily override our logic and amplify our emotional response to events based on how those events measure up to our expectations. When it comes to making decisions about our finances, emotions make poor bedfellows.

In the stock market, expectations are everything. A company can have a great earnings report, but if they’re lower than the market expectations, the stock will most likely lose value. Conversely, if there are poor expectations for a company, its stock can still have great returns if results are better than expected. Stock movements are entirely the result of expectations being weighed vs. reality.

Similarly, portfolio returns overall can be historically “normal,” but if they are out of line with your personal expectations, your emotions can take over and cause you to make irrational (and most likely damaging) decisions in response. Ideally, your outlook on your investment portfolio will not be as volatile as the market, which means it’s important to have rational expectations not subject to dramatic daily swings.

What are “rational” expectations when it comes to portfolio returns? That depends a great deal on how you are invested. There are some truisms that universally apply however. For example, you should not expect double-digit returns every year; that is not a realistic expectation by any measure. You should not even expect positive real (inflation-adjusted) returns every year. If that surprises you, that’s a good indication that your expectations are out of alignment with reality. Here is a common, yet completely unrealistic expectation; “I want to earn a decent return, but I never want to lose money.” You cannot consistently generate real returns without some degree of risk (the risk of “losing” money due to investment volatility or loss of purchasing power) and having that expectation will almost universally cause you to abandon a sound investment strategy at some point in the future. You’re setting yourself up for failure.

Our expectations are the result of innumerable factors, including our understanding of historical averages, recent returns, selection bias, hindsight bias, and our general emotions at any given moment. For this reason, it’s important to work with a professional, who should be as unbiased a source as possible, to help sort through and set realistic expectations. Here are three things you and your advisor should do to guard against irrational expectations (and the potential disasters that come with them).

1. Determine what are realistic expectations;

This will take some work and expertise, as you need to understand the nuances of your portfolio allocation, the reasons behind that allocation, and how that influences what your expectations should be. One of the most common mistakes is anchoring expectations to a common market index, like the Dow, and applying that to your own situation, even if your portfolio has a drastically different composition. Setting realistic expectations must be done in conjunction with your personal situation.

2. Ensure your plan works within those expectations;

Now that you’ve determined what can be reasonably expected from your investment portfolio, review whether that works with what you’re hoping to accomplish in the future. Your goals and reality should match, or changes need to be made. Generally, these changes boil down to three things; save more, spend less, or take more risk.

3. Reset your expectations annually;

Invariably, your expectations will drift through the course of a year. Market dips and swings will cause correlated movements in your expectations. It’s important to reground yourself each year and bring your expectations back to reality. It’s even more critical to do this after a strong run of stock returns (like we’ve had over the past decade) or a string of poor years. Those tend to have a very influential impact on expectations.

If you’re looking for the one true, fail-proof expectation you can apply to the stock or bond market, I’ll pass on my own personal expectation, which I borrowed from John Pierpont Morgan. When asked what the stock market would do that day by an energetic youth looking for an edge, J.P. Morgan replied, “It will fluctuate, young man. It will fluctuate.”

If your expectations are any different, brace yourself for disappointment.

To take an even deeper dive into the idea of how our expectations shape our lives, check out this article about “The Happiness Equation” from the smart folks at Dimensional: The Happiness Equation