One of the most dangerous – and most heavily entrenched – behaviors in the human psyche is extrapolation.
For centuries, the time it took a ship to cross the Atlantic stayed constant at around six to eight weeks. An extrapolator at the time might have said that it would always take around that long.
But then, the modern cruise ship came along, dropping transatlantic crossing times to less than a week. Extrapolate based on that improvement, and you would project crossing times to keep improving. Even so, you’d still have no idea how fast crossings were about to get…
But if you take that rate of improvement, you might think today we should be able to cross the Atlantic in less than 20 minutes.
Now your extrapolation would be too optimistic.
Everyone knows that extrapolating into the future is a bad idea.
You know this… Investors know this…
And yet, everybody keeps doing it.
Today, we’ll look more closely at the problem with extrapolation. And I’ll share what you should be doing instead to grow and preserve your wealth.
We’ll begin with the stock market…
At the start of the year, the market took one heck of a ride higher. It was one of the sharpest “V” shapes we’ve ever seen. Look at this on the chart below, and it almost looks like the time scale has been warped.
The S&P 500 shot up 11% by the end of February alone. That is a solid year’s worth of gains in two months.
Clearly, this level of growth couldn’t have kept up. At that rate, the market would return about 68% for the year. (For comparison, the biggest prior one-year move in the S&P 500 was a 45% gain in 1933, following the Great Depression.)
Still, investors of every stripe love to read the most recent movements of the market and extrapolate. If the market has risen, they are bullish. If it has fallen, they are bearish.
According to the American Association of Individual Investors (“AAII”) Investor Sentiment Survey – which asks investors if they are bullish, bearish, or neutral – the number of bullish investors hits its lowest point whenever the market bottoms. When we checked in on it in February, it had soared above 39%… a high reading. (Look at the six-month moving average in green for a smoother view.)
This is what makes extrapolation dangerous… The crowd bases its expectations on its own short memory and ends up blowing around with the wind. It bounces between impossible hope and bitter disappointment. It’s no wonder how quickly investors cooled off last month as trade-war tensions hit the market.
You need to recognize the truth: Tomorrow will not be like today.
This is not only true for the stock market, but for the economy as well. Consider this final example…
In the decades after World War II, the global economy – and particularly the U.S. economy – saw an incredible boost in wealth.
The miracle reached new heights in 1973, “when average income per person around the world leaped 4.5%,” economist and historian Marc Levinson wrote in his book An Extraordinary Time. “At that rate, a person’s income would double in 16 years, quadruple in 32. Average people everywhere had reason to feel good.”
But they shouldn’t have. Those income levels never materialized…
If you took the 2.8% average growth rate in real per-capita gross domestic product (GDP) from 1950 through 1973 and allowed it to continue, you’d expect each American today to earn $93,863 per year.
Instead, we earn an average of $56,803.
The urge to extrapolate is almost irresistible. We’re built to make these kinds of assumptions. Even babies who see an object in motion can anticipate where it will be a few seconds later.
But this gut feeling falls apart when we apply it to the realms of technology, society, and finance.
So instead of extrapolating about what will happen next in the economy or in the stock market, prepare for the unexpected.
Keep a healthy piece of your portfolio in hedged positions like gold and precious metals. Investors see gold as a safe-haven asset. It should hold its value – or even rise – if the market falls.
If you use a mix of diversified assets and strategies, your portfolio will be much better positioned for whatever comes next. You’ll soon stop extrapolating… and start investing.
Here’s to our health, wealth, and a great retirement,
Dr. David Eifrig
Source: Daily Wealth