Many of our biggest investing mistakes begin with the success of someone else.
Perhaps a friend struck it rich investing in Bitcoin. Or maybe a cousin bought $63,000 worth of Tesla stock in 2018—his investment is now worth more than a million dollars.
We hear these stories and naturally want to imitate their success. So we invest some of our own savings in Bitcoin and buy the latest hot stock on Robinhood.
Unfortunately, these attempts at imitation often end badly.
Most people who try to get rich quick end up getting poor even quicker. Instead of buying low and selling high, they purchase these investments near their peak. The end result is a portfolio full of red ink.
Why do so many people make this basic investing mistake? One of the underlying issues is a behavioral tendency known as over-extrapolation. To see if you’re vulnerable to this cognitive error, answer the three questions below.
The Questions
1) A recent study of kidney cancer finds that those American counties with the lowest cancer rates are mostly rural and sparsely populated. One potential explanation is that these counties have lower rates because people have a healthier lifestyle, and are less exposed to various forms of pollution. How likely do you think this explanation is to be true?
a. Not likely at all [0 points]
b. Unlikely [1 points]
c. Neutral [2 points]
d. Likely [3 points]
e. Extremely likely [4 points]
2) Mary and Marty have three daughters. What are the odds than their next child will be a boy?
a. Greater than 50% [4 points]
b. Less than 50% [4 points]
c. 50% [0 points]
3) A coin has landed on heads 10 times in a row. What are the odds that the next flip will also be heads?
a. Greater than 50% [4 points]
b. Less than 50% [4 points]
c. 50% [0 points]
Answers
How did you do? If you have more than 3 points, you are susceptible to over-extrapolation. Put simply, this is the tendency to assume that the same patterns seen in a small sample can be used to predict the future.
Consider that kidney cancer example. While it’s true that many of the counties with the lowest cancer rates are rural, it’s also true that many of the counties with the highest rates are rural. Why is that? As Daniel Kahneman points out, it’s not because of people in those rural counties lead dramatically different lifestyles, or are exposed to different amounts of pollution. Rather, it has to do with the likelihood of extreme outcomes within a small sample. Because those rural counties have fewer people, they are far more likely to display outlier results, whether it’s higher or lower rates of kidney cancer.
What does excessive extrapolation have to do with losing money in the financial markets? Investors assume that the streaks of the recent past—such as Bitcoin rising in value—can be applied to longer periods of time. Alas, the market is largely a random walk, much like a coin flip. Just because a stock or crypto has been on a roll doesn’t mean it will continue to be on a roll.
If you’re at high risk for over-extrapolation, you should be extra careful about chasing speculative investments. It’s important to remember that nobody knows what’s going to happen next in the markets, which is why it’s best to build a diversified portfolio that can minimize the ups and downs of the market.
If you are still tempted by a speculative investment, you might want to set aside a smaller amount of money that you can afford to lose.
Treat the investment as a fun experiment, much like playing roulette at a casino.
Since you probably won’t get lucky—or at least as lucky as those making the headlines—at least you’ll have had some fun and won’t lose all your savings.
Actions
1) If you are at high risk for over-extrapolation, get more numbers before you make any financial decisions. Consider the long-term, not just the recent past.
2) If you still find yourself tempted by a speculative investment, set aside a small amount of money to play with. Ensure you have guardrails to protect the assets you need to preserve your quality of life.
3) Remember: trying to get rich quick usually leads people to get poor even faster.
Additional reading:
Tversky, Amos, and Daniel Kahneman. "Belief in the law of small numbers." Psychological Bulletin 76.2 (1971): 105.
