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Extrapolation Bias

Extrapolation Bias

31 Jan 2020

Extrapolation bias is also sometimes referred to as ‘recency bias’; this relates to the fact that investors will often seek to identify a pattern in recent events when none actually exists; biased extrapolation can also emerge from ‘representative thinking’.

Two experiment examples follow:

  1. ‘Tony’ is a particularly fit and good looking young man, he drives a Mercedes and has a very attractive girl friend on his arm. Which of the following is most likely:

    1. Tony is a top-flight cricketer?
    2. Tony is a nurse?

    Over many experiments, most people chose A. This is because this answer is most representative in most people’s minds, notwithstanding that, statistically, there are many more male nurses than top-flight cricketers.

  2. Which of the following coin tosses seems most likely?

    1. Heads-Tails-Heads-Tails-Tails-Heads-Tails-Tails-Heads
    2. Heads-Heads-Heads-Heads-Heads-Tails-Tails-Tails-Tails-Tails

    Despite experiment results overwhelming supporting A, the fact is that A and B are equally likely – coins have no memory and therefore there is no pattern from which to extrapolate.

While a full explanation of extrapolation bias is more complex than these brief examples indicate, the fact is that they encapsulate the essence of what this bias is about.

Despite a natural unwillingness to admit to any form of investment (or social) bias, the truth is – and plentiful evidence supports the assertion - that the private investor is far more likely to be influenced by bias than the professional manager.

A key reason for this is that a professional portfolio manager will mitigate bias by using such investment tools as deep research, pricing mechanisms, unemotional analysis, ratio examination and strictly disciplined evaluation. The very last thing a professional manager will do is consult a newspaper for either direction or inspiration.

While private investors will use recent history as a guide, the professional manager will ignore it; where private investors will consider recency, the professional manager will avoid it. While the majority of people will keep forecasting upwards in a rising market, the professional manager will consider each day on its isolated merits – and while many will continue to forecast downwards in a falling market, the professional manager will use proprietary tools to identify buying opportunities.

Extrapolation bias is just one of several to which we are all subject in a variety of different circumstances: what we eat; how we dress; where we vacation.

With investing, however, extrapolation is one bias we should avoid at all costs.

Disclaimer & General Advice Warning

This publication has been prepared by Joseph Palmer & Sons (ABN 29 548 490 818) an Australian Financial Services Licensee (AFSL 247067). Whilst the information contained in this publication has been prepared with all reasonable care from sources, which Joseph Palmer & Sons believes are reliable, no responsibility or liability is accepted by Joseph Palmer & Sons for any errors or omissions or misstatements however caused. Any opinions, forecasts or recommendations reflects the judgment and assumptions of Joseph Palmer & Sons as at the date of publication and may change without notice. Joseph Palmer & Sons, their officers, agents and employees exclude all liability whatsoever, in negligence or otherwise, for any loss or damage relating to this document to the full extent permitted by law. This publication is not and should not be construed as an offer to sell or the solicitation of an offer to purchase or subscribe for any investment. Any securities recommendation contained in this publication is unsolicited general information only. Joseph Palmer & Sons are not aware that any recipient intends to rely on this publication and are not aware of the manner in which a recipient intends to use it. In preparing our information, it is not possible to take into consideration the investment objectives, financial situation or particular needs of any individual recipient. Investors must obtain individual financial advice from their investment advisor to determine whether recommendations contained in this publication are appropriate to their personal investment objectives, financial situation or particular needs before acting on any such recommendations.

Author: Eddie Lees

Categories: Palmer Blog, Behavioural Finance

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