The Hindu Business Line : Tune your expectations

You may have observed that stocks of certain companies decline on the day these companies announce their financial performance, even if it is better than the previous quarter. Can economics explain such behaviour? Behavioural psychologists throw some light on the issue. Suppose a footballer meets with an accident. When he regains consciousness, the doctors tell him that he may be confined to the wheel-chair forever.

Enhancing state of mind

A week later, this footballer responds well to medications and is told that he can walk out of the hospital with a minor limp. The footballer’s career is finished. No coach would want a player with a limp, however talented he might be. Yet, the footballer is ecstatic! Why?

Being confined to a wheel-chair affects the footballer’s way of life. When he is told that he can get away with just a minor limp, he regains this mobility. And that greatly enhances his state of mind. In other words, our reaction to an event is not based on how good or bad that event is. Rather, it is based on our expectations from the event. The footballer is still worse off than he was before the accident. Yet, he is happy that he can walk!

Level of expectations

It is the same with the financial markets. If a company continually announces good performance, we raise our level of expectations. Even if the company delivers 40 per cent growth, the market is not satisfied, as it expects more. This leads to a price decline on the day the company announces its financial performance.

The flip side is also true. Suppose the market expects a company to declare losses but it actually reports a marginal profit. The stock may move up sharply, even though the company’s earnings are substantially lower than its competitor.

The key to happiness, it appears, is low expectations! For having low expectations means less chances of disappointment. That way, a bad outcome can actually feel good if we expect something worse. And a good outcome can feel bad if we expect something better.

(The author is an investment strategist.)

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