“If investing was a cocktail, it would essentially boil down to one part fundamentals and one part emotions. Fundamentals are easier than ever to capture because we now have access to more data in a single day than our ancestors would see in a lifetime.
The emotional component of investing will never be quantifiable because it’s impossible to predict how people will feel in the future.
The late Jack Bogle introduced this concept in his book Don’t Count On It by breaking down expected annual returns of the U.S. stock market into the following components:
Market Returns = Dividend Yield + Earnings Growth +/- Changes in the P/E Ratio
Dividends and earnings are the fundamental portion of stock market returns while the change in the price-to-earnings (P/E) ratio is the speculative portion of returns. The change in P/E represents how much people are willing to pay for corporate fundamentals and the reason it’s considered speculative is because it can vary widely over time.”