People in finance tend to believe (reasonably I think) that the stock market trends upward. I believe they mean it trends upward even after you account for the value of the risk you take on by buying stock in a company (i.e. being in the stock market is not just selling insurance). So how does this mesh with the general belief that the market is at least pretty efficient. Why are we systematically underestimating future returns of companies?
It isn’t just risk that explains why you might not be willing to pay more than $1 for a share that you expect to be worth $1.10 in a year’s time.
First of all (rather trivially, and I am not suggesting you’ve overlooked it) there is inflation. That $1.10 next year is denominated in dollars that will be less valuable than today’s dollar. (Assuming positive inflation rates, which is the usual situation.)
Second, there is opportunity cost. While your money is invested in the company you bought shares in, it isn’t available for you to spend on other things. Hence, even after adjusting for inflation and even if there were no risk involved, if you buy an asset today and sell it in a year, you should expect to be compensated for that inconvenience by getting more for it than you pay. I think this is the main thing you’ve overlooked. Relevant finance term: “risk-free interest rate”.
Third, there is growth. That company you’re buying shares in presumably thinks it is actually adding value to the world through its work—maybe they’re inventing new things, or extracting resources from the ground that were previously embedded in deep rocks and no use to anyone, or trading between people with different utility functions so that everyone gains.
The second and third things there aren’t additive. Growth is what makes it possible for the share to be worth more next year than this year; opportunity cost is what makes it necessary. If a business isn’t able to produce value then no one will want to buy its shares.
So your first and second point make sense to me, they together make the nominal interest rate. What I don’t understand is your point about growth. The price of a stock should be determined by the adjusted future returns of the company right? The growth you speak of should be accounted for already in our models of the future returns. So if the price going up that means the models are underestimating future returns right?
The price of the stock is determined by the anticipated inflation-adjusted future returns (including allowance for risk). But increasing price doesn’t mean the models are underestimating future returns, because of opportunity cost. (Which, again, is basically the flipside of growth.)
If the “risk-free interest rate” is 2% in real terms and inflation is 2%, then that means you can (in principle) buy an asset for $1 and be confident that in a year it will be priced at $1.04, which will have the same purchasing power as $1.02 now. There’s no inconsistency in the fact that this is a higher price than you’re paying now, because if you buy the asset now and sell it next year, you’ve lost the use of your money during that time, and whoever you bought it from has gained it. That matters both because we need money for things like food, and because if you have the use of a pile of money you can try to use it for something that adds value to the world and hence grow it.
People in finance tend to believe (reasonably I think) that the stock market trends upward. I believe they mean it trends upward even after you account for the value of the risk you take on by buying stock in a company (i.e. being in the stock market is not just selling insurance). So how does this mesh with the general belief that the market is at least pretty efficient. Why are we systematically underestimating future returns of companies?
It isn’t just risk that explains why you might not be willing to pay more than $1 for a share that you expect to be worth $1.10 in a year’s time.
First of all (rather trivially, and I am not suggesting you’ve overlooked it) there is inflation. That $1.10 next year is denominated in dollars that will be less valuable than today’s dollar. (Assuming positive inflation rates, which is the usual situation.)
Second, there is opportunity cost. While your money is invested in the company you bought shares in, it isn’t available for you to spend on other things. Hence, even after adjusting for inflation and even if there were no risk involved, if you buy an asset today and sell it in a year, you should expect to be compensated for that inconvenience by getting more for it than you pay. I think this is the main thing you’ve overlooked. Relevant finance term: “risk-free interest rate”.
Third, there is growth. That company you’re buying shares in presumably thinks it is actually adding value to the world through its work—maybe they’re inventing new things, or extracting resources from the ground that were previously embedded in deep rocks and no use to anyone, or trading between people with different utility functions so that everyone gains.
The second and third things there aren’t additive. Growth is what makes it possible for the share to be worth more next year than this year; opportunity cost is what makes it necessary. If a business isn’t able to produce value then no one will want to buy its shares.
So your first and second point make sense to me, they together make the nominal interest rate. What I don’t understand is your point about growth. The price of a stock should be determined by the adjusted future returns of the company right? The growth you speak of should be accounted for already in our models of the future returns. So if the price going up that means the models are underestimating future returns right?
No, that’s not quite it.
The price of the stock is determined by the anticipated inflation-adjusted future returns (including allowance for risk). But increasing price doesn’t mean the models are underestimating future returns, because of opportunity cost. (Which, again, is basically the flipside of growth.)
If the “risk-free interest rate” is 2% in real terms and inflation is 2%, then that means you can (in principle) buy an asset for $1 and be confident that in a year it will be priced at $1.04, which will have the same purchasing power as $1.02 now. There’s no inconsistency in the fact that this is a higher price than you’re paying now, because if you buy the asset now and sell it next year, you’ve lost the use of your money during that time, and whoever you bought it from has gained it. That matters both because we need money for things like food, and because if you have the use of a pile of money you can try to use it for something that adds value to the world and hence grow it.
[EDITED to fix a trivial typo.]