Back to posts

Extrapolation Bias

February 3, 2023 | Posted in: Insights, Investing

A common investor mistake involves extrapolation bias which is the strong tendency to project recent trends into the future. In reality, markets and economies tend to be quite cyclical, and regression to the mean is a particularly powerful force. Here are several examples of sharp reversals of trends that had caused considerably anxiety in the financial world.

First, used car prices rose 57% between June of 2020 and January of 2022 strongly contributing to the overall surge in inflation in the U.S. Well, used car prices have fallen in each of the past six months with a cumulative decline of about 10% with further decreases expected as demand moderates. Second, as depicted in the following graphic, which was provided by Visual Capitalist, the Freightos Baltic Shipping Index measures the global average cost of moving a forty-foot container by ship. The index rose from $1,461 in January of 2020 to a peak of $10,996 in September of 2021, again causing great consternation and contributing to global inflation. The index is now at $2,178.

In a related statistic, there were many articles in the media describing the backlog of unloaded ships at the Port of Los Angeles. That trend has now reversed as inbound traffic in December was down 20% versus a year earlier and volumes have been below 2019 levels since last August. Finally, recall the shortage of computer chips that hindered the production of consumer electronics, autos, and many other products. Some chips are still in short supply, but those found in consumer goods are now experiencing a major glut. Inventories have tripled, memory chip production in South Korea is down 25%, and prices have fallen by as much as 40%.
The point is that successful investors participate in the long-term healthy growth of the economy while tuning out the short-term swings because they are generally self-correcting. So, don’t despair!!