Question

One of the most commonly seen disclaimers in money management and financial planning is “past performance is not necessarily indicative of future results.” Or something like that! As a naive planner, I used to shrug this statement off and often wonder how else we were supposed to forecast! But now in reality, after years of seeing this take shape, this statement is really representativeness and the extrapolation bias, and I see it all the time in practice.

Here’s a twist-what do you think happens when overconfidence and extrapolation come together to form one dangerous combo behavior?

Answer 1

In my opinion, overconfidence in any aspect of financial matters is dangerous. Extrapolation involves using information/data relating to past/recent events as the basis for making decisions/assumptions/predictions about future. If too much confidence is placed in this technique (extrapolation), an investor/financial planner is likely to make financial decisions only with reference to past performance of the company/sector/industry. However, it is highly likely that the future performance may not turn out to be as forecasted/predicted based on previous events. This could affect the value of financial investments and holdings of the investor.

Overconfidence and extrapolation bias may affect the investor's ability to make a sound financial judgement as all the decisions would be based on the assumption that information obtained from analysis of past/recents events is representative of future performance which may not actually be true. Actual performance may also be affected by political, social and economic factors which cannot be forecasted with the use of analysis of past/recent events. Therefore, it is essential to perform a fundamental analysis of the asset/company/industry (in which an individual plans to invest) including an analysis of external factors. This technique when combined with extrapolation is likely to produce better results and reduce the risks for the investors.