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Why Chasing Expectations Is a Fool's Errand

How could the Patriots do so poorly in the expectations game while kicking proverbial butt in the real game? It is because expectations know no bounds.
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As the NFL season winds down and the New England Patriots and New York Giants have advanced to the conference championships -- one game away from a potential re-match in Super Bowl XLVI on February 5, 2012 -- the minds of many NFL fans are taken back to the magical 2007 season. The Patriots dominated the league becoming the first team in NFL history to go 16-0 in the regular season (the 1972 Miami Dolphins had gone undefeated in a shorter 14-game season). In the regular season, the Patriots were brilliant. Tom Brady threw for a record 50 touchdown passes. Randy Moss caught a record 23 touchdown passes. The average margin of victory during the regular season was 20 points. They crushed the Jacksonville Jaguars (31-20) and San Diego Chargers (21-12) to get to the Super Bowl with an 18-0 record.

The Giants, who barely made the playoffs in the National Football Conference as a wild card team, then beat Tampa Bay then eked out close contests at Dallas and Green Bay to make it to the Super Bowl as a substantial underdog. And in a thrilling game that featured an improbable game-saving catch by David Tyree, the Giants prevented the Patriots from achieving the first 19-0 season in NFL history by winning 17-14.

In the real game -- the game played by real teams on a real field for a real 60 minutes with real scores and a real winner and a real loser -- the 2007 New England Patriots were a whisker away from being the most dominant team in NFL history.

However, in the NFL there is a parallel game that gets played every week: betting on NFL football. That is an expectations game; one in which during the week bettors imagine what will transpire on Sunday (or Monday night) and on the basis of those expectations will place their bet on one team or the other. Fans know that their expectations form the 'point spread' -- the amount of points the underdog is 'given' -- i.e. has added to their score to determine the winner in the expectations game -- in order for the Las Vegas bookies to even the dollar volume of betting on either side.

While New England went a near-perfect 18-1 in the real game played on the field, they did remarkably poorly in the expectations game, going 10-6 against the point spread in the regular season and 10-9 overall. This is mediocrity exemplified. In contrast, the lowly Cleveland Browns, who missed the playoffs, went 12-4 against the point spread.

How could this be? How could the Patriots do so badly in the expectations game while kicking proverbial butt in the real game? It is because expectations know no bounds. In the first half of the regular season, the Patriots went 8-0 in the real game and 8-0 against the spread. In those 8 games, the Patriots were favored by an average point spread of 10.5 points. Then the expectations jumped because of the Patriots dominating performance in the real game; in the back half of the regular season, the average point spread in favor of the Patriots rose to 16.5 points and guess what? The Patriots went 2-6 against the point spread. In those last eight games, the Patriots faced the three highest point spreads ever recorded in NFL betting -- including 22.5 points in the second-to-last regular season game against the Miami Dolphins. In the real game they killed the Dolphins 28-7; but in the expectations game they lost.

Point spreads stayed high in the playoffs where they usually narrow dramatically because only the top 12 teams make the playoffs. The Patriots were favored against the Jaguars by 13 points in the first round and won by a comfortable 11 points, which failed to cover the spread. Then they were favored against the Chargers by 14.5 points (no play-off spread has been this wide since that game) and also won by a comfortable 9 points, which failed to cover the spread. And they went into the Super Bowl with a huge 12-point spread and lost, which automatically failed to cover.

Why does this all matter to business? First, the structure is identical to business. Businesses play a real game, making real products/services, selling them to real customers for real money and earn a real profit (or loss). In parallel, there is an expectations game, in which investors, the equivalent of NFL bettors, imagine what the firm is going to accomplish in the future and on the basis of those expectations buy or sell stock in the company -- which sets a stock price, a sum that is identical to a betting point spread. Both are the product of the consensus of expectations by all bettors/investors.

Second, the 2007 New England Patriots demonstrate that no matter how great you are in the real game, you can't keep meeting expectations forever. A team that went 10-1 in the real game in the second half of the regular season and playoffs went 2-9 in the expectations game.

Third, the data show that it took American public company CEOs about 15 years after the advent of stock-based compensation around 1980 to figure out the second point above. After they figured it out in the mid-1990s, they started spending massive amounts of time and energy managing expectations rather than managing the real business -- that is when earnings guidance started and earnings manipulation (companies started magically beating consensus analyst estimates 70% of the time rather than the expected and historical 50%) and in due course massive accounting fraud. In addition, CEO tenure plummeted at CEOs realized that since you can't keep beating expectations forever, it is smarter to jerk expectations up in the short-term and then get out and cash in your stock-based compensation before it falls back down again.

Imagine if after winning his 18th consecutive game by handily beating the San Diego Chargers in the American Football Conference championship game, superstar quarterback Tom Brady came to the press conference head down, chagrined and announced: "I want to apologize to all of you here. We tried our very best and left everything on the field today. But we failed. You expected us to win by 14.5 points and we fell substantially short of the goal, winning by a mere 9 points. I have no excuse. We just didn't have the plan or the execution to accomplish what we needed. But I promise you; we are not taking this lightly. We have two weeks before the Super Bowl and I have just informed the team that we are going to be doing a major restructuring. We have fired the offensive line and will be bringing in a new one. And we have released our field goal kicker and will be trying to find a new one in time for the Super Bowl. Ladies and gentlemen, you can rest assured that we will not fail you another time."

That would be utterly preposterous -- unimaginable. But it what CEOs have to do every quarter. Chasing expectations is a fool's errand -- but it is the dominant game being played in American business today.