Financially Speaking Blog

The Perils of Extrapolation

Published on February 7, 2013

Several years ago, I spoke to a group in Jonesboro on “Five Financial Mistakes Smart People Make”.   One of the points I made was the mistake of extrapolating current trends into long-term trends.  An example I gave related to the price of oil.  Back in the early 80’s, the price of oil had increased to historical levels-around $75 per barrel.  Oil had been around $20 since 1947 and beginning in 1973, we endured a series of Middle East geopolitical events.  The experts predicted the trend to continue which would take the price of oil to unimaginable prices.  Based on those expectations, oil should have been trading at about $300 per barrel at the time of my talk.  But, in fact, it was trading at only $10 per barrel.

 

We often see these mistakes made by well-educated, experienced experts.  Why do even smart people make these mistakes?

 

The Wall St. Journal reported on study published in the Journal of Neuroscience that looked at how people use past rewards to predict future payoffs.  Participants in the study appeared to be extrapolating their most recent experience into the future.  The study explained that a region of our brain, the frontopolar cortex, “is critical to advanced mental functions such as memory, exploring new environments and making decisions about the future.”  The scientist discovered that we tend to make decisions based largely on how much short-term reward we received.  In other words, the greater the recent payoff, the more likely we expected that to continue.

 

So you don’t have to be smart to make the mistake of extrapolation.  We are wired to make this mistake, and it happens all the time.  For example, think about the market price of Apple stock.  The stock chart went up like the side of Mt. Everest.  That is until last fall.  Now the chart looks like the other side of Mt. Everest.  There are countless examples in investment history when people buy because they extrapolate the recent stock prices–only to watch their investment lose money. 

 

I think it’s better to think that the more something goes up the sooner it will come down–expect it to come down.  And the more it goes down, expect it to come up.  It is much easier to manage all this with an investment plan that eliminates our mental errors.  But some smart people just never figure that out. 

Tags: behaviorial economics; investment decisions

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