Reasonable Expectations

Reasonable expectations are a form of risk control. If return goals are too high, too smooth, or too dependable relative to the risk being taken, investors are likely to accept hidden danger.

Core Idea

Howard Marks argues that every investment effort should begin with explicit and realistic expectations:

• What return is being sought?
• How much risk can be tolerated?
• How much liquidity is needed?
• Is the promised return reasonable relative to alternatives?
• What must be true for the return to be achieved?

Unreasonable expectations push investors toward leverage, illiquidity, complexity, weak due diligence, and suspension of disbelief.

Too Good to Be True

The key test is simple: if a return appears high, smooth, and dependable, ask whether that combination makes sense. Madoff is Marks' extreme example: investors accepted equity-like returns with bond-like smoothness because they wanted the impossible to be true.

Marks' practical questions:

• Is this too good to be true?
• Why is this opportunity being offered to me?
• Which source of return explains it: depressed purchase price, rare skill, risk bearing, leverage, or luck?
• If none explains it, what am I missing?

Connections

• bubble-detection - Bubbles often depend on unreasonable expectations becoming socially accepted.
• credit-cycle - Easy credit lets borrowers and investors act on unrealistic return assumptions.
• decision-quality-vs-outcome - Good expectations are probabilistic, not guaranteed.
• epistemic-humility - Requires admitting what cannot be known or promised.

Sources

• the-most-important-thing-illuminated - Chapter 20, "Reasonable Expectations."