Do you ever find yourself swept up in emotions when it comes to your investments? What if you could learn to manage expectations and make more informed decisions based on data? Join us in this eye-opening episode where we explore the art of expectation management in investing and life in general. We even take a look at the world of baseball to see how expectations can be used for predictions on the outcome of a game or specific play.
We dive into various investment analysis strategies, such as technical analysis, macroeconomic analysis, analyst estimates, and company-specific factors, to help you better understand the market and determine the value of your investments.
Lastly, we examine the earnings yield and its inverse relationship with the P/E ratio, using ExxonMobil and Apple as case studies. We discuss the cautionary tale of Nvidia and the low expectation of returns when overpaying for stock. Plus, we touch on FP Canada's more complex portfolio guidelines that provide an expectation of returns for a globally diversified stock portfolio for the year 2023.
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Hello and welcome back to the Canadian Money Roadmap Podcast. I'm your host, evan Neufeld. Today we're looking at kind of a big picture concept for shaping how you view your investing and other parts of your life. I guess too, when we're talking about expected returns, when it comes to almost anything in life, expectation management is so important. How much you enjoy your vacation, how much you're going to enjoy a movie, what you think of your job, how painful a medical procedure is going to be all these different things revolve around our idea of expectations What we think is going to happen versus reality In your investing life. Expectation management is also really important because it helps take some of the emotions out of investing. It helps you ignore the noise on the extreme ends of the fear and greed spectrum because if you know what to expect or have a reasonable guide to point you to what you should expect, you're way less likely to be drawn in by something that might be a scam or too good to be true or to get too down when things don't work out as expected. Expectations will also help build your projections of the future and guide how much you need to be saving. So are you saving based on the assumption that you'll get 12% returns per year for the rest of your life, or maybe 3%. How do you know what's reasonable? So, without a expectation that's rooted in something reliable, you're guessing, you're hoping, you're wishing, you're gambling and you're probably ignoring reality to some extent. So today I'm going to talk a little bit about expectations and how you can think about that for your own life and for your investments. So let's start by looking at some examples of how you can use expectations and other parts of your life. I'm going to talk about a few nerdy things maybe, but one of the best sports for using data to guide expectations it's got to be baseball. There's so many crazy stats in baseball because it's such a high volume game where a batter might have four or five times up at the plate every game and they play 162 games a year. It's unbelievable the volume of data that you can get from baseball. So one of the things that I've enjoyed poking around at is looking at expected runs in baseball to kind of you can kind of gauge a scenario to see what's likely to happen. Because, just as a pure fan which is the fun part, to be completely honest the fun part about baseball is just watching and not knowing what could happen next. So say that the Blue Jays are down two runs and they've got runners on first and third two outs. What are the chances that they can actually pull this off? This happened recently and so I'm watching it and we've got a few hits in a row and I was like, okay, we're rolling, we're rolling. Now Vladdy's coming up to the plate. He's a good hitter. I feel like he's going to hit a home run here. Chapman isn't good against lefties. There's no way to have all these different things. You start feeling. But you can actually calculate these things. So there is a few different stats that you can look at that calculates all these different scenarios based on how many outs there are and all the different positions on base. So if you're not a baseball fan, there's first, second, third base and you're out after the third out, and so there could be any number of scenarios between having zero outs, one out and two outs and runners nowhere, or on any combination of the three bases. So there's 24 different potential outcomes there. So within that the crazy people behind Saber Metrics they put together all this data to figure out what the odds are in any given scenario And then you can benchmark that against what actually happens to a player and things like that. But for an example here, let's say there's no outs and you've got a runner on third base. It's pretty close to coming home, you can have a sack fly all these different scenarios. The expected runs for the rest of the inning in this case is 1.35. So if you're in a scenario where this happens, it's more likely than not that you're actually going to score a run here. Are there scenarios where you don't score a run Absolutely, absolutely. But we use expectations to guide decision making And in the case of baseball, you can have a little bit of fun with those when you're watching the game. So in this case, here again, no outs, runners on third base, you're batting. The most probable outcome is actually one run, even though the expected runs are a little bit higher than that. Okay, because expectations aren't guarantees. Expectations are based on a large data set of what you could expect on an average over a long enough period of time. So let's give an extreme end of the other side where expectations didn't necessarily matter. So a couple of weeks ago Blue Jays were playing against the Tampa Bay Rays and they're in the ninth inning and there's two outs, no one on base And I think it was the first baseman was pitching like this game was a blowout. It was a bit of a joke, but the Blue Jays are hitting again two outs, no one's on base. The expected runs in this scenario were 0.09. Okay, so you should expect that this game is done And they just they end it right there. However, what happened after that is they scored nine runs. Okay, and in the data set that I'm looking at here, this has happened nine times before. It goes back to 1957. And so the probability of that happening was 0.00047. The probability was really low, but it still happened right. So just because you can have expected returns or expected outcomes, that doesn't mean that it can't happen, but you shouldn't be watching a game or planning for that if you're the the coach. It's just not realistic. Let's put that unrealistic expectations into another context. Let's say you're playing the lottery, so I don't know if the Lotto 649 is something across Canada, but we've got that here in Western Canada. Essentially, the way that that works is that you pick six numbers between 1 and 49. If you get all six right, you get your share of the grand prize, which I think is $5 million. So the way that you calculate the odds, essentially you've got pretty close to 1 in 14 million odds of winning That prize. So it's not astronomical, but it's pretty high. You don't have a really good chance of winning here. But the way that we can kind of figure out your expected returns here is if you multiply your odds of winning by the prize value, you get your expected return. So in this specific lottery case, you should expect to win $0.36 per ticket, which costs $3. Right, so you should expect to lose $2.64 every time you play the lottery. So again, what I'm saying here is that even though there is a winner and you can win and I know people that have won actually the expected returns are still 0. So should you play the lottery expecting to win? No, is it possible to win? Yes, you just shouldn't expect it. Okay, so if I'm planning my financial life, i'm not looping in lottery tickets as a way to increase my odds of success, because it has expected returns of 0. Same thing goes for things like cryptocurrency, even like regular currency, like US dollars or whatever precious metals, like gold or silver, collectibles, baseball cards, nfts, whatever. You want to collect The expected returns of something when we start talking about the stock market or an investment, or properties or anything like that, are based on expected cash flows generated by an asset or something that has an intrinsic value, like a property, things like gold and silver. They don't spit off any cash flow. Cryptocurrency don't get me started on that. I'm not a believer in the investability of crypto because you can't value it. From my perspective, there's some ways, i guess, that you could throw a value on it, but those things that are purely speculative or their values driven by just supply and demand in that moment or perceived scarcity, to me that's not a reliable way to invest because it carries additional risk. Like the value there is subjective, it can be influenced by speculation, by others market preferences. These kind of things I don't believe are reliable, and so I don't assign expected returns to things like cryptocurrencies, precious metals, collectibles, anything like that. So when we talk about the stock market, how can we actually take a look at these things? Because there should be expected returns for these assets bonds as well but I'm just going to talk about stocks today. How can you actually look at these things and put a value towards them? Well, there's a couple of different ways that you can look at it. One would be historical analysis. I don't agree with this one necessarily, because it just says okay, well, what did it do in the past and what's it going to do in the future? This is like the classic disclaimer, like past performance, it does not guarantee future results. I would say sure, maybe it's a bit of a guide, but it's not super reliable. Next one would be fundamental analysis. So it looks at a company's financial statements how much money they're making, what assets they have. You can assess factors like revenue, growth, profitability, debt levels, industry dynamics, and then you can kind of extrapolate those over the future as well. So I would be more of a fundamental analysis proponent, but I'll come back to that in a second. Another way you could look at it is technical analysis. Again, i think this is a complete waste of time. This is like astrology for finance nerds. You take a look at different charts and they start throwing lines up there. It's like, oh, this is a head and shoulders pattern, or you know, we're working on a double bottom here, like all these different patterns and whatever that they see in price charts and based on trading volume and trend lines, moving averages. It's not all hocus pocus, but most of the scammy things that I see on the internet related to money have to do with technical analysis, because it seems like magic and it's complicated and it seems like someone could have an edge in this way. I don't believe it's true. I don't think it's complete zero, but I wouldn't waste any time valuing the market on technical analysis. Another thing we could do is economic analysis. Over the last year or so, this has kind of been where people have come out of the woodwork and suddenly become economic experts, because the things that are driving the market were things that were largely big picture, like inflation and interest rates. That has not been the case for the better part of the last 40 years, and so the people that have really focused on macro analysis Ray Dahlia would be one. If you've ever heard of him, he runs a massive hedge fund. They're few and far between. This stuff is very complicated and there's a lot of trickle-down effects when you start looking at the different economic indicators and factors around the world and how they impact global markets and so on and so forth. Even the experts that are pulling the strings on this and the strings on these things at central banks and whatnot. They've got all the information that you could possibly want in this regard, and oftentimes they're playing catch-up. So investing based on the macro economic outlook seems intuitive, but it's also virtually impossible, so I don't put a ton of weight there necessarily. Another one would be seeing what other people think. So call it analyst estimates or worse what does your brother-in-law say about it? But even experts here. They'll meet with management of the companies and they'll take a look at the products, what they've got in the pipeline. But you can look at qualitative and quantitative things within it company-specific factors, industry trends, market conditions, a little bit more under the hood type of analysis, and a lot of times that can be a really good way to do it. It's just really difficult for individual investors to do that If you're looking for that kind of thing. Active mutual funds or hedge funds have been the traditional way to get access to this amount of volume of information, because these funds and fund companies have armies of analysts that are doing this all around the world. Do not try to compete with them. If you think that there is value to be had here, just use them. If you don't believe in the value that they had, just Don't go that route at all and don't think that you can outsmart these people that are spending Billions and billions of dollars Trying to get an edge in the market. So when you see a headline on CNBC or Bloomberg or Reddit and then you start buying and selling stocks based on that, it's like sorry, you are late to the party, okay. So the thing that I take a look at most For for a high value expected return calculation usually looks at valuations. So that's kind of the fundamental analysis of like a market or a stock, you know. And so the idea there is if you're looking at valuation and saying, what are you paying today for the assets and cash flows of the company? So if you're owning them for into the future, it's always going to be higher than what the value is today, assuming that company grows over time. So we would look at the valuation of a company. One of the easiest ones are the most commonly quoted ones. That people look at is something called the P? e ratio or the price to earnings ratio. What this looks at is what is the price of a stock versus how much money does it make? earnings is a kind of corporate jargon for profits, and so I've just pulled up the S&P 500 PE chart here and You can take a look at different parts of the market and you can see what are you paying today for earnings in the future. Let's use a few examples here. Apple, biggest company in the world Currently. They have a price to earnings ratio of 29.8. Let's call it 30. Essentially what that means is that you're paying when you buy a share of Apple. You're paying 30 times the profit that it currently makes to own it. So if you think of it in payback terms, it'll kind of make your money back over 30 years, assuming the company doesn't grow at all. Apple is probably one of the most growth-oriented companies in the history of the planet. So we would probably expect some growth over time. But but that's not a bargain necessarily. All depends on the growth rate of the company and things like that. But that's that one metric that you can look at there. Let's compare that to something That's really a completely different field. Let's look at Exxon mobiles. So right now, exxon has a price to earnings ratio of seven, seven point one. There's a number of reasons for this, and low doesn't mean good, high doesn't mean bad. But I'm just kind of showing you some examples of where these could fall. So, on that same note, exxon would take about seven years for you to get your money back at the same level of earnings, assuming they actually share those earnings with you as as shareholders. So I'm of the belief, largely speaking, that There is money to be made in looking for low-priced stocks. We call those value stocks. I've talked about that on the podcast before. If you want to go look at that, that episode about value investing, you can do that. I'll probably do some more about that in the future. But historically speaking, buying stocks that are in the lower third evaluations have typically driven Higher returns over time. So how do we use this PE ratio To get a bit of a guess on future returns? again, this is an exhaustive. This is not super scientific, it's just kind of a little bit of a quick guess or a quick rule of thumb. Way that you can look at this is by using the PE ratio. And So if you just say if you take one divided by the PE ratio or the inverse Some sometimes earnings to price then sometimes we call that the earnings yield. So let's use ExxonMobil, for example, here. So I'm taking one divided by 7.11 today that gives me 14%. So rough and dirty rule of thumb if you're investing in ExxonMobil, perhaps that could be a rate of return that you could use as a rough Expectation in the future. Alternatively, let's look at Apple. So I got one divided by 30. It's closer to 3.3%. It's like hmm, why is that the case? Well, let's just look at it logically here. Perhaps if Apple is the biggest company in the world, is it possible that they can continue to grow earnings as fast as they did in the past? or Is it possible that once you get so big and everybody has an iPhone and so on and so forth, maybe your growth rate starts to slow down a little bit? and so the reasonable Expectations. From where Apple is today, it's highly, highly unlikely that they'll be as high as they were in the past during their massive growth phase. So this kind of makes an intuitive sense right Prices which you pay, but values which you get right. So if you're overpaying for profits today, it's gonna be really tough to make returns in the future. Let's use a crazy example of Nvidia. If you've never heard of Nvidia before, you probably should, and you're gonna hear about them a lot Very soon, because they make all the computer chips that most of the AI Platforms are using behind the scenes to actually run all the artificial intelligence software. There are a few other companies, but Nvidia is the biggest and baddest and they recently released their earnings with their expectations of future revenues, and The stock price took off like crazy. So in videos of very volatile, stock is down, i think about 70% last year, but then this year It's already up 166%. Oh, my goodness, crazy. And so if you're looking at Nvidia saying, my goodness, it's up 166%. I gotta buy some of this because it's gonna keep going. Think about it. What are the odds that this thing keeps going up at the same rate? I would say very low, very low. The way that the stock is priced right now, it is already pricing in massive growth in the future. Massive growth because, if you look at a few different valuation metrics I'm just gonna stick with price to earnings because that's the one that I was using before. Exxonmobile's got a 7 PE, apple's got a 30. Nvidia is currently at a 202 price to earnings ratio. Okay, it's gonna take you 200 years to get your money back, based on current earnings. So this company's gotta grow like mad for you to ever be able to make money today. Right, if you bought this stock six months ago, you're laughing Right. But if you're buying it today, your expectation of returns cannot be the same thing. It's possible. Let's use that lottery example again. It's possible. But you're buying a lottery ticket When you overpay for a stock today. You are buying a lottery ticket, hoping that you're the one that wins the five million bucks when your expected returns are zero. Let's do the same exercise here with Nvidia. One divided by 202, your expected returns on this stock from today again just based on my rough and dirty earnings yield math 0.5%. Okay. So I say this as a cautionary tale. Based on this concept of expectation management, if you're looking at an individual stock that has recently gone up, your expectation for returns in the future should not be based on historical returns. Meaning, what did it do yesterday? Try to reassure yourself that you are late to the party, and that's okay, because if you're owning a broadly diversified portfolio, you probably own a little bit of Nvidia anyways, but that's another conversation. But if you're buying it after a stock has already gone up so much and it's expensive, based on how much profit it's making, you cannot expect that the future returns will look anything like the ones in the past. Okay, so what are some actual numbers that we can use here going forward, fp Canada, so financial planning Canada. They provide a bit of a guide based on a number of things. They use all sorts of different projections based on the economy evaluations and all those kinds of things which I've already talked about, which is great, and so us, as financial planners, we use the guidelines, which are much more complicated than just doing a inverse of a PE ratio, but they use these to kind of guide how we build portfolios for clients and how we use them as guidelines for future projections. So the way that I typically build portfolios for clients, i like having globally diversified portfolios. So some Canada, some US, some international, some emerging markets each of these have different expected rates of return. If you go back to my episode about building your first 100,000 in the stock market, i have a little spreadsheet there that you can download that includes these guidelines for 2023 for each of those different categories. But, broadly speaking, if you're invested in a globally diversified stock portfolio, maybe using an asset allocation ETF or something similar, the expectation for returns would probably be in that ballpark of about 6.3%, depending on whether you're doing it yourself or how you're building your portfolio. It could be reasonable to go 1% in either direction there as far as an estimate goes, but that's the number that I think would be completely reasonable for you to use as far as your long-term projections go. There are gonna be years where it's much better than that. There's gonna be years where it's much worse than that, but you could have a reasonable expectation of that on average over your investing life And I think you'd be in pretty good shape by using that as kind of your guidepost Now if something underperforms. So if you have a year where you're down 10%, no, that is a possible outcome at any given point. However, the next year your expectation should probably be the same, if not actually a little bit higher. Vanguard is a company that I've talked about before. The US Capital Markets Division actually puts together some modeling for future expected returns. They use three main elements to come up with their projected returns. They say number one a global dynamic model that forecasts the drivers of long-term asset returns, such as yield curves and equity market valuations. Number two attribution models that attribute asset returns to the drivers. And three, simulation engine to model the probability distribution of outcomes. Okay, what does that actually mean? They say, okay, what actually drives returns of the market, one of those largely being valuation, like I already discussed and then they use simulations to say, okay, how often does this actually happen? Looking at the past, looking at volatility, what are things that you can reasonably use? And they use something called a Monte Carlo analysis for that, which is pretty cool, and I can use that with my clients as well on our financial plans. So I'm a big believer in using expectations to guide, both the average, which is kind of what we've been talking about so far, but also the potential downside, or the volatility. Along with that, vanguard caught some heat for their return projections as of the end of 2021. And they were saying that US equities should, over the next 10 years, should provide the returns in the realm of 2% to 4%. And people are just losing their mind. It's like what? This is crazy. And their justification for that was based on the valuations. So the end of 2021, stocks had kind of been going crazy at the end of 2020, so coming out of COVID and continuing on, and that's right when this whole inflation thing started to hit, but before interest rates started going up. So when interest rates are really, really low, markets are gonna keep going regardless of valuations. So the valuations of the stock market started to get really, really crazy. It made sense, but it guided the expectations of the future. So if you were putting money in on December 31st of 2021, you could not expect that that dollar would continue to earn the same types of returns that you'd seen in the markets in the previous two, which is why people were kind of losing their minds. Now, those same returns today for US equities from Vanguard, they project that to be between 4.1 and 6.1. Again, pretty close to what I was saying before. And that is based on what? the fact that valuations have improved, so stocks aren't nearly as expensive as they were two years ago, and so you can reasonably expect that, going forward, the returns on those stocks should actually be better. Okay, so that's how you can kind of use valuation as a bit of a guide for your expectations. Pe ratio is one if you really want to get nerdy and look into something called the CAPE ratio. That's called the cyclically adjusted price to earnings ratio or the Schiller PE. There's some really cool research around that kind of thing. It just kind of puts the PE ratio on steroids a little bit, but I think that understanding valuation is really, really important, so you don't get caught up in these ideas of chasing returns or recency bias, just thinking things that will continue on the same pace forever. Last little example of this outside of the investing world Recently there was a major golf tournament and one of the invitees was a golf pro, essentially from a local course. This isn't Dustin Johnson or Tiger Woods or Rory McElroy here. This guy's name is Michael Block. He's in his 40s and he teaches lessons and he kind of runs a golf course. He's a pretty average guy but golf is his job, but he doesn't get to play that much because he's actually got to run a course and give lessons and all that kind of stuff. Anyways, he got invited to this tournament. They do that from time to time. He did exceptionally well. He made it to the final round of this major tournament. I think he finished in the top 10 or the top 15 or something like that, which is unbelievable against the best golfers in the world Everybody. The story is going all over the place. It's like, wow, this guy is great, imagine if he had another chance. So the next tournament, those coming up. It's like, hey, we'll send an invite out to this guy and kind of keep this story going. He's given interviews and someone's like hey, you got to play with Rory McElroy, what's the difference between your game and his? And he said, oh well, if I could hit it as far as Rory McElroy, i'd be right up there with the best in the world. The guy's like really, oh, yeah for sure, my putting and my chipping is absolutely elite. Whatever all this kind of stuff. He was reading his own book there. Fast forward to this past weekend where he got invited to the next tournament in the calendar. It's called the Charles Schwab challenge And a lot of the golfers you know and love would be in this tournament. And you know Michael Block. You know all lies are on him. This guy that's kind of coming out of nowhere. Can he do it again? Nope, got dead last, i literally dead last And he didn't make the cut, which means he only made it through the first two rounds And he got last. Does that mean he's actually the worst golfer there? No, was he actually the 15th best golfer in the world based on last tournament? No, the expectations for this guy. He's like yeah, he's probably a pretty good golfer. Could he reliably compete consistently with the best in the world, i'm going to say probably not Right. So when you invest, maybe you're picking individual stocks. I don't recommend it. But if you're doing that, maybe take a valuation approach. Maybe buy stuff that has a reasonable expectation of future returns, as opposed to buying stuff that had already gone up. To reference another episode that I just did, reviewing Ramit Sadie's Netflix series called How to Get Rich, one of the people featured on the show did this exact thing where, during the pandemic, he thought he'd get smart and try to pick stocks And he bought draft Kings and he proceeded to lose almost $80,000 on this because, guess what? He bought it after it had already gone up It already had baked in all of the growth and turns out, the future expected returns on that, when his stock is very, very expensive. I don't even know if draft Kings is profitable. To be completely honest, that's another wrinkle. If a company doesn't even make profit, their PE ratio is going to be infinite. So if you see a company that has no data for a PE ratio, i would say double check your expectations on that. You could see some growth over time. just purely on speculation, i would say it's largely unfounded based on anything that's reliable. So if you're going to throw some money on it, assume that it's going to be a bit of a gamble, but know that your expected returns on that are going to be pretty low. Anyways, hopefully this is kind of an interesting conversation here, just about expectations, some things that you could expect, some things to avoid. The biggest thing I hope you get take away from this is that when you see headlines of a stock that's really taking off it's Nvidia today, it was GameStop yesterday. Whatever it is, use a framework of expectations or expected returns in the future to guide your decision making. Do you really think it's going to keep going up forever, maybe? What other things can we use to make sure that when we're investing in the markets, we're making good decisions? Hopefully some conversations around expectation management here help with that And hopefully you can make better decisions with your investments going forward. Thanks so much for listening. We'll catch you on the next episode. Thanks for listening to this episode of the Canadian Money Roadmap Podcast. Any rates of return or investments discussed are historical or hypothetical and are intended to be used for educational purposes only. You should always consult with your financial, legal and tax advisors before making changes to your financial plan. Evan Neufeld is a certified financial planner and registered investment fund advisor. Mutual funds and ETFs are provided by Sterling Mutuals Inc.