The dangers of extrapolation

Taking past performance, building a compelling narrative to explain it and extrapolating forward is a common way for many investors to try and make sense of the world around them. We examine the potential pitfalls of positioning portfolios using this approach and look for better ways to go about it.

An unknowable future

While 2020 has been difficult to predict, this year has highlighted the importance of keeping a firm eye on the probabilities of events occurring when making decisions today. While the future is unknowable, the past is not. One intuitive and common way for investors to anticipate the future is to extrapolate from previous results. This can however create a host of problems.

Why we extrapolate

Human beings do not generally like uncertainty. Extrapolation can help us deal with this. If the future is unknowable, a sensible approach can be to start with what is known. After all, the future builds on the past. However, human beings do not just draw lines to extend past trends forward. We are social animals and part of the stories we tell as well.

Extrapolation in investment often involves taking a significant past performance pattern, constructing a simple narrative to explain it and then considering whether the narrative will apply to the future. Compelling narratives can then be created to justify why past performance has been particularly strong or weak, and then used to predict its continuation.

The pitfalls

When market moves are explained, they are typically explained in a way that suggests the story drives the price. In hindsight, even the most complex events can make perfect sense when the story is explained to us. The problem is these explanations usually come after the event.

Post-rationalisations can be dangerous because extrapolation is circular and narratives can become self-fulfilling. Investment decisions can be made on the basis of events that are not true. Financial markets involve so many moving parts, that in many occasions it is difficult to provide complete explanations for events. Often, even the most experienced investment professionals differ in opinion.

Does the evidence support the story?

Narratives are powerful because they can feel right, especially if there is some evidence to support them. Whether the causal relationship the narrative seeks to explain is strong can become immaterial; what matters is that the story is convincing. Once the link has been forged, it can be hard to break in an investor’s mind. Additionally, the simpler the narrative, the easier it is for it to be understood, shared and to therefore take hold as the prevailing explanation. Therefore, stories which are missing key variables and are extreme simplifications can capture investors’ attention.

Confirmation bias, a natural tendency to seek out, interpret, favour and recall information in a way that confirms and supports one’s prior beliefs or values, can further exacerbate the situation.

Investment mistakes

Simple narratives can be relatively harmless if just being used to explain the past. However, they can be dangerous when used to set future expectations and allocations. They can encourage overconfidence in our predictions. In addition, diversification is often sidelined when holding strong convictions, which may result in over-concentration in an investor’s portfolio. Extreme examples involve people investing in sectors or stocks at the heights of bubbles, when the most believable prevailing narratives about how dizzying heights could be sustained can seduce investors.

While extrapolation has its drawbacks, sustained trends should not be ignored. A behavioural pitfall with investing is to view performance relative to when the position was first entered into and if performance has been strong and persistent, to expect a correction. The reality is that the market does not care about when you invested; if the case for the trend is solid, reversion does not have to be inevitable.

Preparing for after the pandemic

Life has changed dramatically as a result of the COVID-19 pandemic, with significant impacts upon many sectors of the economy. Some trends that were underway, such as working from home, have accelerated rapidly this year. As Microsoft chief executive officer, Satya Nadella, succinctly put it: “We’ve seen two years’ worth of digital transformation in two months.” Certain sectors have profited greatly, one being the tech sector which has led the recovery in equities since March’s sell-off.

As we prepare for a transition to a post-pandemic world, there will inevitably be winners and losers. Increased e-commerce adoption for example seems to be here to stay, especially if the pandemic isn’t brought under control rapidly. However, many are predicting long-term structural changes based on events occurring during the pandemic. This is a very unusual, uncertain and short period of time upon which to draw any strong conclusions or make predictions.

The field of behavioural economics shows us that it can be difficult to create lasting behaviour change. While it seems very difficult to imagine things going back to what they were like at the start of 2020, investors should be conscious that our perception is altered when we are in a “hot state” (such as living through the COVID-19 outbreak).

Many behaviours (and thus the implications on sectors) may not be permanently altered once the pandemic is over. When extrapolating, structural changes are often implied when in reality much market behaviour is cyclical.

A way forward

So how should investors be thinking about the future given the present uncertainty? We recommend taking a long-term view of investing, and constructing a well-diversified portfolio of high-quality companies.

Take a broader view based on all available data, avoiding getting caught up with individual stories and remembering that the news can itself be biased and produce noise which may be unhelpful to an investor.

A trusted advisor can help to make sense of competing narratives and reach a point of view that is based on careful rational data analysis and a diversity of views from professionals. When thinking long term, as we have discussed many times in this publication, it becomes clear that a well-diversified portfolio is the best protection for the unknowable future.

Focus on actively selecting quality companies

Narratives that are overly simple view the market as a single entity, or all companies in a sector as identical. We recommend protecting yourself from that thinking and the market reactions (or overreactions) to such narratives can be accomplished through two, interlinked strategies.

While structural changes can lead to even the strongest companies falling out of favour, holding quality companies can protect a portfolio from market shocks. Active management rather than passive exposure to markets also appeals, to ensure that a portfolio consists of the strongest constituent companies best placed to thrive, whatever tomorrow looks like.

The world around us might be in constant flux. However, by understanding and addressing our behavioural biases, portfolios never should be.

Investments can fall as well as rise in value. Your capital or the income generated from your investment may be at risk.

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