Successful stock investment does not require investing in companies with higher expected earnings. The reason is simple. You pay a higher stock price for companies that are expected to be more successful. However, retail investors often neglect this important principle when thinking about stock returns, which reveals an important gap in households’ financial literacy.
Imagine you learn that Nike — the US sportswear giant — has announced that it can cut production costs by 20 percent. The news is four weeks old. Industry experts predict that this unexpected success will significantly strengthen Nike’s market position in the sports apparel industry. Would you conclude that this is a good time to invest in Nike stock?
Here’s another thought experiment. Imagine that you learn that German Council of Economic Experts substantially updated its growth prognosis for the German economy. They expect the German economy to grow much more than originally projected. The announcement was made four weeks ago. Finally, some good news! Would you conclude that this is a good time to invest in the German stock market?
Lower production costs mean higher future earnings for Nike, and a stronger economy means higher future earnings for German companies. But do higher expected future earnings for the companies mean higher expected future returns on an investment in the companies? The answer surprises many retail investors: Higher expected future company earnings do not directly imply higher expected investment returns.
Current stock prices reflect future expectations
The reason for this is that stock markets are forward-looking. Expectations about future profits and dividends are already reflected in today’s stock prices. In both thought experiments, the news was four weeks old, which left the stock market ample time to respond to the news. If market participants expect higher earnings and dividends in the future, they will have a higher demand for the stock, and the current stock price will be higher. The attractiveness of an investment is therefore not simply determined by the expected earnings of a company but — loosely speaking — by the expected success relative to its current stock price. To the extent that stock prices correctly reflect what is known about the future, expected future earnings are even irrelevant for future returns.
Few retail investors understand the relation between expected earnings and stock returns
Our SAFE Working Paper shows that few retail investors understand this principle. In thought experiments like the ones described above, retail investors usually predict higher returns on an investment in a company even weeks after good news about the future earnings prospects of a company were announced. We find this effect among US and German households, including those who regularly invest in the stock market. Moreover, they document the same degree of misunderstanding among financial advisors, analysts, and traders who advise and trade on behalf of households in the US. This reflects a widespread and fundamental misunderstanding of how returns arise on markets.
An important facet of financial literacy
This finding might help us understand four costly and common investment mistakes.
(1) Too much trading: If retail investors believe that stale news about future corporate earnings promises higher future stock returns, this invites frequent trading and portfolio adjustments. However, such trades are costly but rarely come with higher expected returns, thus lowering the effective return of the investment strategy.
(2) Under-diversification: If retail investors believe that returns are predictable, they might underestimate the risk of individual stock investments and hold under-diversified portfolios. This means they expose themselves to unnecessary risks.
(3) Non-participation: Many households do not invest in the stock market. Many might be cautious because they believe they know too little about the business world to identify the best-performing companies reliably. But this means they miss out on a valuable opportunity for long-term investing.
(4) Pay too high costs: Other households prefer active investment funds, believing that experts are best able to identify the companies with high expected earnings. But high fees significantly lower the effective returns of such actively managed funds. In fact, actively managed funds often struggle to outperform passive funds after fee deduction.
The fact that stock prices are forward-looking means that investing in the stock market is — in many respects — much easier than retail investors think. Future expected company earnings matter only to the extent that they are not fully reflected in today’s stock prices. But households do not need to participate in this complicated guessing game. They do not need to outsmart the market. Instead, they can earn the average market return by investing in large and broadly diversified index funds (ETFs) with low fees.
Peter Andre is an Assistant Professor for Behavioral Finance at SAFE.
Philipp Schirmer is a Ph.D. candidate in economics at University of Bonn.
Johannes Wohlfart is an Associate Professor of Economics at University of Cologne.
Blog entries represent the authors‘ personal opinion and do not necessarily reflect the views of the Leibniz Institute for Financial Research SAFE or its staff.
