Happiness is reality minus expectations

David MoonBlog

Tom Magliozzi, co-host of NPR’s Car Talk show, described the formula for happiness as reality minus expectations. The equation is simple; people are generally happy when the reality of life is better anticipated. Unreasonably high expectations are often a recipe for disappointment. This same formula can be loosely applied in the evaluation of investment outcomes.

Too often, investors flock toward the strategy of owning the most high-flying growth stocks, choosing to avoid pesky details such as price. The problem with this approach is that it rejects any acknowledgement that all investments should be measured against expectations. Being the first to recognize a great company can be a profitable investment strategy. However, buying a great company when the market is in wide agreement on its greatness is a different proposition entirely.

The second and third quarter recovery in the S&P 500 obscures an extreme divergence across security prices. The record recovery has been driven almost entirely by a handful of companies, all of which benefit from the stay-at-home economy and the acceleration e-commerce trends. These large technology stocks, commonly described as the FAANG stocks (Facebook, Apple, Amazon, Netflix and Google), are great businesses, but the expectations for these businesses are at a premium – both compared to the overall U.S. economy and to recent expectations for those companies.

In a pattern resembling the tech bubble of the late 1990s, a new wave of investors appears to be caught up in the exuberance of expecting that buying companies with great growth automatically means making a lot of money. However, thinking this way leaves out a critical piece of the investing equation: price.

As an analogy, consider another form of speculation: pari-mutuel betting. If the pricing of odds were irrelevant, almost everyone would consistently bet on the favorite at the horse race. Instead, the goal of a gambler is to choose the horse whose odds are mispriced relative to the potential outcome of the race. In other words, the money is made in betting on the horse that will perform in a way that exceeds expectations.

Whether at the horse track or in the stock market, simply betting on the favorite is both easy and popular, but usually not a sound proposition. Betting on the favorite requires risking larger sums to produce even modest payoffs.

Buying the best companies is not the same as buying the best investments. Investors who think the two are equivalent are, in a sense, betting blindfolded, as they are refusing to account for the odds offered by the market. Like horses that come up short, higher expectations for a company increase the likelihood of a negative result from the “reality minus expectations” formula.

David Moon is president of Moon Capital Management. A version of this piece originally appeared in the USA TODAY NETWORK.