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Suppose everyone expects Apple to increase its earnings by 20% next year. Due to the general expectation, the current stock price will incorporate this information. For example, if subsequently Apple reports earnings that vindicates everyone's expectations, Apple's stock price will change by approximately $0, ceteris paribus. From my understanding, if everyone has the same expectations of an investment, the NPV of the investment is $0, because the expectations will be priced-in in such a way that makes the NPV = $0.

I've been looking at index funds (e.g. S&P 500 ETFs). These funds seem to be commonly recommended for people with long investment horizons who want a passive diversified exposure to stocks. It appears that index funds are generally recommended on the basis that they "tend to increase in value over the long-run". From my observations, this "passive index fund investing" style has a very large following, especially in the US. For the moment, let us ignore the potential objections to the belief that index funds "tend to increase in value over the long-run", and let us assume that index funds are really going to increase in value in the future. Issues:

  • If the value of index funds is generally expected to increase, and people now continue to pump money into index funds in the belief that the values will materialize, wouldn't the future returns be approximately $0, as in the case of Apple illustrated above?

  • What prevents the future expectations of index fund performance from being priced-in at this very moment, thus ensuring that future returns will be mediocre?

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  • Future behavior is not often what you expect. – jamesqf Jul 23 '20 at 3:17
  • If everyone expects index funds to increase in value in the future, what are they going to do? Short the shares? Not buy the index funds? It's a Captain Obvious answer: If the expectation is up and it results in net aggregate buying volume then share price rises. – Bob Baerker Jul 23 '20 at 3:25
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    "Suppose everyone expects Apple to increase its earnings by 20% next year. " Won't happen. Earnings Estimate is an average consensus. Apart from the average figure, there exists variation among analysts, and the underlying probability distribution. Given that earnings are not guaranteed, there is risk premium on top of risk free rate. – base64 Jul 23 '20 at 5:37
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    @user253751 - The word "Should" is irrelevant in a market that is determined by an auction. Or as Keynes said, "The market can remain irrational longer than you can remain solvent." – Bob Baerker Jul 23 '20 at 12:15
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Argument 1

Theoretically, a rational investor would make a list of all the possible investment portfolios and products that he can buy and choose which gives him the most utility. So even if there was no uncertainty on the future and every investor agrees that the price tomorrow would be higher than the price today, this opportunity could not be arbitraged away, since people would prefer buying some product today than investing with zero expected return.

So even a risk-free investment could still have an expected return higher than zero, to compensate investors for the loss of utility for consuming.

Argument 2

So even if everyone agrees that the stock market tends to grow in the long-term, still investor has to be compensated for the risk they are incurring. Basically, if the expected return was zero from an investment, I would prefer to leave my money on my mattress than putting on an index fund. So the expected return also has to compensate for the distribution of expected returns of the investment portfolio.

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You seem to be unclear on what "NPV" means. It stands for "net present value". The "net" part means you you subtract off any costs, such as initial investment. The "present" part refers to the idea that to compare money in the future to money in the present, you should discount it for inflation, time value of money, and risk. NPV includes all costs including opportunity cost. If Investment A has returns of 11%, but you have to give up Investment B with returns of 10%, then the NPV of the opportunity to make Investment A is only 1% (approximately; strictly speaking the rates are divided rather than subtracted). So just because the NPV is zero doesn't mean that the returns are zero.

See, for instance, https://www.investopedia.com/terms/n/npv.asp

NPV = sum ( (R_t/((1+i)^t) )
where:
R_t = Net cash inflow-outflows during a single period t
i = Discount rate or return that could be earned in alternative investments
t = Number of timer periods

[I think "timer" is a typo.] ​

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To craft a precise argument to the question you have to include 2 co-ordinates to the "expectations" part. First as mentioned is "return" the second co-ordinate is "time". Not including both will make arguments ambiguous where everyone keeps going around in circles e.g., the word "future" which could mean tomorrow or hundred years later and as everyone knows even a broken clock shows the right time two times each day.

Hypothetically, Apple is expected to increase profits by 20% next year, so the price today is expected to go up by 20% making returns for someone who buys tomorrow and holds till next year equal to 0. However, when you consider that next year the price is again expected to increase by 20% the person who buys tomorrow will stand to gain 20% two years later. The person gains 20% in two years compared to someone who bought today who will gain 40% and holds for 2 years which is nearly half the return (50%).

Now putting time in perspective, Apple will continue to make 20% year after year after year for 10 years in this case the person who will buy tomorrow loses only 1 yr of return in the next 10 years (10%) and closes the gap with the one who buys today. Extend this argument for 100 years. You will see that you will continue to make only 1% less than who bought today. This is basically Buffett and Munger's idea of buying companies which are expected to earn decent return on capital for long periods.

Now what actually happens in the stock market: Apple is expected to make 20% return in the next year, everyone piles in and stock zooms more than 20% making returns negative for the following year and this continues as buyers pile in and then when people stop buying it falls. This keeps happening over and over. Now combining this with the above long term perspective. Someone who will want to buy for 10 years will most probably pay a higher price because you can still earn good return in the later years. However, the one who wants to buy to capture the 20% return next year has no way to do that.

Considering that stock prices don't move in steps of next year's returns and actually move in smaller fractions and also that people have different expectations of next year's returns (20% would be the average of all analysts covering the stock with a wide band) and putting the time horizon of investment along, you can say that they price at which the stock should trade is an equilibrium price of the expectations of all the investors in the market with different expectations at that point in time. When participants, expectations, time horizons change the price changes too. This leaves time periods when you could buy stocks/ETF when they match your return expectations — if you required 20% return next year, you wouldn't buy till the price falls to allow you to get it which means if it doesn't fall then you can't enter but you may settle for 10% return next year and 20% for the following 5 years while Buffett may but even if it climbs another 20% because he doesn't plan on selling it. Ever.

I've only scratched the surface here there's a lot more to this.

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"Suppose everyone expects Apple to increase its earnings by 20% next year. Due to the general expectation, the current stock price will incorporate this information."

(Unfortunately) That sentence is completely, totally, wholly, absolutely wrong.

Of the people who sit around theorizing about "why" stock prices are what they are, a few of them happen to theorize that "earnings" have something to do with "stock prices" (and there are innumerable totally divergent sub-theories in that world). There are others who believe that "earnings" have utterly no connection to "stock prices", and there are others who have wholly divergent and unrelated views.

Nobody has any clue, at all - whatsoever - why stock prices are what they are.

In the question, OP, you mention one particular whacky theory "about stock prices" and then elaborate on it and ask questions about it, but (unfortunately) the basis is wholly meaningless.

Sentences like "earnings affect stock prices!" are random collections of meaningless words.

(Rather like, say, "wine language" when people supposedly describe high-end wines - totally meaningless babble; or, as there used to be an entire "science" of phrenology, which was completely, utterly, meaningless babble, developed to an amazingly intricate state with equations! and so on.)

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  • "earnings affect stock prices" is not a random collection of meaningless words... either earnings affect stock prices, or they do not, and I think you'll agree that precisely one of those theories is obvious BS. – user253751 Jul 23 '20 at 16:03

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