What Is Extrapolation Bias And Why Care?

What Is Extrapolation Bias And Why Care?

In 2013 the U.S. stock market had its best return in over 15 years.  When you reviewed your portfolio in January of 2014, did you add to your investment in U.S. stocks because they did so well the previous year?  If so, then you were guilty of what is called in the jargon of behavioral finance “extrapolation bias,” the tendency to overweight recent events when making decisions about the future.

Don’t feel bad.  2014 also turned out to be a good year for U.S. stocks, although not surprisingly a bit more muted than 2013.  And you can also be forgiven due to the fact that this bias tends to be more pronounced at the beginning of each year.  As human beings we are all emotionally wired to want to invest in those assets that are performing well and to eschew those that are not.  Extrapolation bias (also known as “recency bias”) is unfortunately a very real challenge that we must learn to overcome if we are to invest rationally.

Here’s another example.  Have you ever flipped a coin a number of times in a row and gotten all heads?  If so, what did you expect to get on the next flip?  If you’re like most people, the answer is tails.  But even if you flipped twenty heads in a row, the statistical likelihood of getting a tail on the next flip is still 50%.  Many people struggle to intuitively grasp that fact.

Dan Gardner, the author of Future Babble – a highly-recommended book asserting that expert predictions are generally worthless – explains that one of the reasons it’s so difficult to accurately predict the future is because it is hard for us to see in any direction other than a straight line.  It’s easiest to take what we currently know and project it forward.  In the 1980s just about everyone was predicting that by the early 21st century the U.S. will run out of oil because demand continues to increase while our supply is measurably dwindling.  What was not anticipated were new technologies enabling the extraction of oil from deep deposits of shale, not to mention improvements in alternative sources of energy, energy utilization efficiency, and conservation.  Last year the price of oil fell by 50% and, depending on the industry’s ability to overcome a number of environmental issues, the U.S. has the potential to become a net oil exporter within the next five to ten years.  There was no one back in the 1980s offering any such prognostication.

When applied to investing, extrapolation bias causes us to do exactly the opposite of the mantra we hear all the time, namely that “past performance does not guarantee future results.”  From the vantage point of January 2015 this bias would tell us to avoid foreign stocks (especially emerging market stocks) because they did so poorly last year, to increase investments in U.S. stock because they did so well, and to sell all our commodities investments (such as oil) because their prices will continue to plummet.  While I don’t know what 2015 will bring, I’m confident that is not the right way to make good investment decisions.

Fortunately there’s an easy way to avoid extrapolation bias in your investment planning, and that is to rebalance your holdings each year (or at least periodically).  That means selling some of those assets that performed well the previous year and buying more of those that did poorly.  For 2015, that would mean doing exactly the opposite of what extrapolation bias would have you do, namely reducing your U.S. stock holdings and increasing foreign stocks and commodities.  I am not suggesting this is what everyone should do, however.  It depends on the allocation model that is part of your investment strategy.

Which brings me to the most important point: you need a financial plan and an investment strategy created to support that plan before you can decide how to rebalance appropriately.  Without it you have little basis for making a rebalancing decision, which leaves you vulnerable to extrapolation bias as your default decision criteria.  Planning is the most effective way to get around the emotional biases that color our investment decision-making.  Don’t invest (or listen to investment advice) without having a plan.  It’s one of the best protections against your emotional self!

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