Investors love extrapolating – assuming current trends will continue well into the future without changing. They want to find patterns and straight lines within a randomly ordered world with few patterns or straight lines.
It’s easy for you to imagine current trends continuing as they are now, but more difficult to consider that people adapt and change.
Not all extrapolation is bad. Scientists use extrapolation as they build foundations for a hypothesis. When you are creating something, you extrapolate things you know and apply this to things you don’t know.
You learn things, both good and bad, from direct experiences. Your experiences, by definition, are in the past – you learn in hindsight.
But you want to forecast these experiences into the future and that’s where the appeal of extrapolation comes into play.
WHY EXTRAPOLATION CREATES PROBLEMS
We’ve had numerous client meetings where the client expresses, “because this happened during the past year, in 10 years I’ll have this much money.” You can’t rely on this type of extrapolation except as a very rough sketch of the future. As the saying goes, “history doesn’t repeat itself, but it often rhymes.”
You might be tempted to extrapolate because you desire certitude in your financial future. However, you can’t make the future certain and extrapolation just provides the appearance of certainty.
Computer-generated financial plans full of extrapolations are pushed on investors as a way of quenching their thirst for certainty. However, you shouldn’t make financial decisions based on most long-range projections because there will always be surprises that can’t be realistically modeled. Unfortunately, the main objective of many financial plans is to predict the future, even though that’s not possible.
Your particular real-life financial planning outcomes will contain elements of both the expected and the unexpected. In fact, Professor Ken French says “unexpected returns typically dominate expected returns.” This touches on just how important it is to have a plan to deal with things not unfolding precisely as you expect. Things will never happen exactly as you planned.
David Booth, Co-Founder of Dimensional says, “you can’t control markets, so don’t blame yourself for results outside your control.”
HOW TO IMPROVE YOUR DECISION-MAKING
Financial planning becomes successful when you commit to the long-term process without regard to short-term events. Lost in the obsession with the short-term is this truth – your long-term outcomes are derived from following a well-defined financial planning process and letting the process stay in place long enough to work.
A good financial planning process focuses on being less wrong instead of getting everything right. American sculptor Elizabeth King says, “Process saves us from the poverty of our intentions.”
Extrapolation doesn’t help your cause. Long-term planning outcomes happen because of preparation, not prediction. Strip away precision from your expectations in order to improve your financial decision-making. Start there.
Related: Inflation: Perception Versus Reality