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The Dangers of Faulty Intuition and Extrapolation

February 28, 2012 | About:
Ale Schuvaks

Ale Schuvaks

2 followers
This article pretends to analyze why value investing has brought solid results. The answer to the question can be obtained by describing three aspects: faulty intuition, extrapolation and optimism.

In terms of faulty intuition, it is necessary to start with an example. Let´s suppose two experiments are carried out. In the first a coin is flipped nine times and the results are recorded. The results — heads (H) or tails (T) — are as follows:

T-T-H-T-H-H-T-H-T.

In the second experiment, the same coin is used and flipped again. But this time, the results recorded are the following: T-T-T-H-H-H-H-H-H.

Now the issue is which of the two experiments is more probable in the outcome. If the experiment is repeated many other times, which is the pattern that will occur with more frequency. The first experiment or the second?

When people see the results, they tend to believe that the first pattern is more likely to occur. Why is it that? Because it seems that the first is more likely even if there is no evidence to support their belief. They just feel that it is the correct answer. They believe the second pattern is more unlikely.

However, both outcomes are equally probable. It is not likely that one will occur with more frequency than the other. Now, let´s suppose the coin is flipped a tenth time in the first experiment. In this case people will believe that this tenth outcome is almost impossible to predict. Yet in the second experiment they would make a prediction. This misperception is the essence of faulty intuition.

Choosing one possible result rather than the other, or seeing a pattern in random, short-term events is highly common and is what most stock market analysts do. In fact, there’s an entire school of investment thought devoted to finding patterns in the short-term movement of stock prices. It’s called technical analysis. Those who use this approach study patterns in past stock prices to predict future price movements. They may look for patterns such as “head and shoulders” or “ascending triangles or spend time on trend analysis. However there are those who do not call this process investing. They consider that this is speculation and has the same chance as long-term success.

Now, let´s move to extrapolation. Extrapolation is basing a longer-term forecast on an emotional reaction to short-term developments. In other words, it is the process by means of which patters are established to explain random events with the idea to predict the future.

It is very common for market participants to look at a negative short performance and say “I think that if this goes on, I´ll lose all my money in 3 weeks”. Or, if they are performing well, “At this rate, I´ll quadruple my money in 6 months.” Unfortunately, the results are rarely as good or as bad as people predict. Market participants generally prepare themselves for disappointments or surprises and the real world events turn out to be different from expectations.

For instance, market analysts tend to project historical trends too far into the future. They project sales, earnings, stock prices, and many other statistics for years or decades despite evidence that these quantities are inherently difficult to predict. In doing so, their expectations are linked to the past though growth rates usually revert toward an average.

There are two things to bear in mind as regards market analysts´ predictions. They are rewarded for doing the thorough job and extending a projection of growth rate in a computerized world is an easy way to look impressively thorough and secondly, it is necessary to be aware of the projection and whether it extends beyond such analyst´s expectations in that job.

For instance, in the year 2000, during the technology stock boom, a very important analyst predicted that the share price of QUALCOMM, a telecommunications company, would climb from $125 to $250. He based his forecast on the extrapolation of the sale of cell phones over 20 years. However, he did not consider the possibility that the firm´s technology could be replaced, or that the usage of cell phones could drop or that other competitors would “steal” QUALCOMM´s customers.

So it is important to bear in mind that making long-term projections on what has been done in the past is really dangerous. In the case of QUALCOMM the stock price did not climb. On the contrary, it fell to $30 in 2002.


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