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:
- ‘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:
- Tony is a top-flight cricketer?
- 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.
- Which of the following coin tosses seems most likely?
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.
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