Extrapolation Bias

Extrapolation bias is a tendency to take recent experience and project that it will continue into the future. We tend to think in a straight line. And it is very hard for us to imagine or perceive future anomalies. A most common way this occurs in finance is when valuing a company. If the company had a 25% earnings for the past 3 years, we are easily drawn to choosing the forecast value for the coming years to be 25% as well. But that is far from certain. The ability of a business to create value in the past does not readily influence it’s ability to do the same in the future. It is the same as correlating a coin toss in the past to another one that is going to take place. Here, we know that the previous coin toss outcome does not influence the nest one. The worst part of this bias is that it is very easy to take a decision with an underlying assumption that the status quo will be maintained in the future.

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