The Fallacy of Extrapolation

The two-year period from 2007 to 2008 saw an epic drought seize the Southeast. Streams dried up, water usage in some areas was rationed (not restricted, mind you, but actually rationed) and crops turned to dust in the fields. It got so bad in these parts that at times you began to feel like you were living in a Steinbeck novel.

For residents of North Georgia, though, the most unsettling part of it all was watching our primary water source, Lake Lanier, dwindle day by day, literally going down the drain and evaporating into thin air simultaneously. During the worst of it, in December 2007, the lake’s level dropped 21 feet below full pool, and the Army Corps of Engineers estimated that Atlanta had a three-month supply of water remaining. People in other parts of the country began to tell me they were praying for me when they learned I was from Atlanta. I think when people you don’t know tell you they’re praying for you that’s a pretty good indicator your situation is dire.

Dire it was. The experts said that it would take years – perhaps a decade – to refill Lanier, and that was assuming we got a decent amount of rainfall. Some of the real doom-and-gloomers posited that the South was in a permanently drier climate now and doubted that Lanier would ever again reach full pool.

 “Lake” Lanier in late 2007

I mention this because, over the past week in Atlanta, we have received between 15 and 20 inches of rain, depending on where you live. It has been the kind of rain you would expect to run across in, say, the rainforests of Borneo, but not in Atlanta. The rains spawned an epic flood – perhaps greater than a 100-year flood – in a year that was already well above average in rainfall. Having already come up more than 12 feet this year, Lake Lanier has now come up another four feet in only a week. By the time all of the runoff from this week’s deluge makes its way into the basin, the lake will be almost full.

In less than a year.

Lake Lanier in September 2009

This is a great example of the fallacy of extrapolation; the tendency of layman and expert alike to take the recent past – the known – and project it into the unknown future as if events are already a foregone conclusion. We can see that we are in an epic drought, we can see the implications of that drought, and we project that into the future and see that it will be many years before the lake is back where it needs to be. What we can’t possibly see is that the weather patterns are going to change faster than anyone thought possible and fill the lake back up in months instead of years.

Extrapolating is an innate human tendency, something that tugs on all of our emotions as we try to get out ahead of events, whether to prepare for them, avoid them or profit from them. We look at things as they have been, and as they are, and we convince ourselves that that is how they will be, too. And yet, more often than not, our foregone conclusions are really false assumptions.

The tendency is pervasive in nearly all human endeavors, none more so than investing. (As an aside, that was 558 words before I got the investment angle in – a new Tranquil Investor record!) I have had thousands of meetings with investors over the years, and in nearly all those meetings I have found folks have a powerful tendency to extrapolate the present into the future, and a keen desire to make investment decisions accordingly.

In the past two decades, I have heard that Japan is the only logical place to invest. I have heard that Blue Chips are going to rule the day forever. I have heard that we are in a New Era and earnings don’t matter. I have heard that bank stocks are “safe.” I have heard that the market is broken and we need to get out before we lose what money we have left. I have heard all these assertions and many more, and they all proved to be wrong.

Presently the extrapolation that I am hearing at every turn is that gold is the only logical place to be because the government is printing money left and right, and it is a foregone conclusion that hyper-inflation is not only likely, but actually inevitable.

I am here to tell you, folks, that there is no such thing as inevitable when it comes to investing. An event observed is an event altered. When millions of people begin making investment decisions based on an assumption such as, “We are going to have high inflation in the future,” their very actions begin to alter the event. If, say, a few hundred million people run to gold in anticipation of high inflation, wouldn’t you think that might impact the price, and thus the future expected return, of gold? And simultaneously create value in the very areas of the market that are being shunned?

You can provide me all the foregone conclusions you want, with all your supporting documentation, and you will not convince me that your scenario is inevitable. You may convince me that such a scenario is possible. Maybe even probable. But never inevitable.

And that is an important distinction, because “possible” and “probable” are hardly compelling enough words to bet one’s life savings on. If you need proof, just find someone who bet last year that $200 a barrel oil was “inevitable.”

They can testify for you…