Extrapolation Bias

Behavioral finance is a branch of economics that seeks to explain why investors frequently have irrational expectations, which can lead to poor decision making.  There is a growing body of evidence to suggest that humans are plagued with a myriad of biases that can prevent us from being rational investors.  As investment managers, part of our role in achieving strong long-term results is to be aware of these factors and consciously make bias-free decisions about the future.  In this blog, we will highlight one important bias that can lead investors to make poor predictions about future investment returns.

Extrapolation bias is the tendency to take a recent experience and project that it will continue into the future.  For example, if a company has grown its earnings by 25% in each of the past three years, we may project that it will grow earnings at 25% far into the future.  Using this simplistic analysis, there are many variables we are not taking into account, and we are likely to be incorrect the farther into the future we project this rate.

If our investments return 10% this year, we can sometimes think that they will return 10% per year into the future.  Similarly, if our investments declined by 5% this year, we may think that we are now likely to lose 5% each year.  In both cases, this simple and emotional feeling has no direct correlation with what will happen in the future – in fact, there are many variables that will determine future investment returns.  The reality is that investment returns have fluctuated greatly from year to year.  Since 1950 the average one-year return for the S&P 500 (i.e. the average of every 252 business day period) was 9.20%, while the best one-year return was 72.32% and the worst was -50.68%.

The folly of the extrapolation bias is well illustrated in a round of golf.  If you birdied the first hole in your round, it is unreasonable to believe (even for the best golfer among us) that you would birdie each hole thereafter and finish your round 18 under par.  We know from experience that what we do on one hole has little correlation to what we do on the next hole – weather, wind, swing, lie, bounce, thoughts, distractions, and innumerable other factors are at play.

Projecting investment returns into the future will not necessarily be any more valid than projecting your golf score.  It is important to be aware of and recognize this bias, and make evaluations based on more relevant factors that are more valuable in assessing probabilities of future success.  Is the investment process you are using straightforward and easy to understand?  Is your investment team experienced and trustworthy?  Is there a sound investment discipline in place that prevents falling victim to whims, trends and fads of the day?

We have always believed that the key to long-term investment success is a disciplined process, and encourage all of our investors to be aware of the extrapolation bias – specifically that returns in any short-term period are less meaningful than the investment process implemented over the long-term.

Daily index values obtained from Yahoo Finance from 1/1/1950-6/29/18. The figures quoted are for illustrative purposes only and are not intended as investment advice. Past performance does not guarantee future results. The S&P 500 Index is a market cap weighted basket of 500 leading companies in the U.S. that capture 80% coverage of available market capitalization. Indices cannot be invested in directly. Draw downs represent the percentage decline in index value from the previous peak.  Price Return does not take into account the payment or reinvestment of dividends.

Carl is a Senior Investment Manager based in the Shenandoah office. Carl is a CFP and has 40 years of experience in banking and investment management. For feedback or questions regarding this blog post, please contact Carl at carl@aowealth.com.