Lucifer, Beelzebub, El Diablo, the Price of Darkness: THE DEVIL!  Yes, sometimes extrapolation is the devil.

Shall I explain?  I shall.

You see, when we extrapolate we are taking current data we have observed, and we project that same data into the future.  This can have it’s benefits.  However, the projection of current witnessed data can burn you like the Prince of Darkness himself.

For example: my stock was $100 three months ago and today its $90, so I extrapolate the decline, and I decide to sell the stock because I think it will continue decreasing.  Then it turns out two months down the road the stock goes to $110… and you basically hate your life.

Just think about the word itself and you will get why it can be the Lucifer of investing:

Extrapolation – Ex.: as in your crazy ex girlfriend.  -trap: as in the time your crazy ex girlfriend tried to trap you in an interstate bathroom and steal your car.  -olation: as in the process by which metal ions form polymetric oxides in aqueous solution…Just like the time your crazy ex girlfriend tried to trap you in a polymetric oxide aqueous solution in an interstate bathroom!

Ok, so I don’t really know anything about chemistry so I may have messed up the context of that last one, but you get the picture.

We extrapolate in investing both on the downside and on the upside.  Think about it, if you didn’t extrapolate, you wouldn’t care about a stock’s decline.  You are usually extrapolating that the decline will continue due to current witnessed data of it taking a krap.  Or, on the other side, you purchase a stock due to witnessing an increase in its price, and extrapolate that price increase into the future.

Extrapolation can really be a biatch.  But what in the world can we do to prevent this phenomenon from killing our investments?

I would argue that extrapolation can be a problem more for those who trade and less for the long term investor.  If someone takes part in the act of actively trading, short term moves mean a lot to the investor.  Removing extrapolation is really hard when an investor is a trader, and not a long term investor.

If I own a Taco Bell franchise, do I get a quote on the price I can sell my franchise on a daily basis?  Absolutely not.  I could care less about the price my franchise can be sold on the market, because I generate income and profit from that franchise.  If  I was able to receive a daily quote on my Taco Bell franchise, I may extrapolate the daily price moves.  This may lead me to do something completely idiotic; like sell a perfectly performing cash generating machine.  All due to the fact I was able to receive a quoted price.

What if instead of receiving a quote on the price of my Taco Bell franchise, I decided to use options to generate income.  Maybe I view the price moves of my Taco Bell franchise and come to the conclusion that it is going to decrease in value.  I do my due diligence of course, so I use my computer software to tell me the chances of my Taco Bell decreasing in value.  I like that the computer model agrees with my feeling of extrapolating it’s decrease in price.  And computer models have to be correct because it’s really easy for computer models to predict the chances of a stock gaining or loosing value in short periods of time (this is me being sarcastic).

So I sell a call against my Taco Bell and receive income for the call.  The 15% chance the genious computers give the price of my franchise declining comes true, and now some 25 year old sitting in his boxers at his home outside Chicago owns my Taco Bell franchise.

Obviously this is far fetched considering the franchise would not be traded on the open market.  But you get the point hopefully.  Extrapolation of price moves is necessary when trading.  And not paying attention to price moves is impossible when trading.  So, just as I don’t care about the price of my Taco Bell on a daily basis, don’t trade stocks on a daily basis.

There are 3 ways to combat the problem with extrapolating price movies.

The first answer is to do a valuation on the company whose stock you are purchasing.

Only a small percentage of people should do this since it takes a lot of work and a deep understanding of accounting, business and financial principals.

Another answer is to just decide when you purchase a stock, you will be owning it for a very, very, long time.

I would say at minimum 5 years plus.  That way, you may not care what it does over the first 2-3 years.  But I would prefer a 10 year or more holding period personally.

The last answer to solving the problem with extrapolation is to figure out if you are a net buyer of stocks.

If you are a net buyer of stocks over your lifetime, just add money to an index fund on a reoccurring basis and never touch the money until you are getting close to retirement.

It’s safe to extrapolate a gain in the stock market over a long period of time.

For example, if you are 40 years old and will be retiring at 65 years old, you have 25 years left purchasing stock.  So you are a net buyer of stock over your lifetime.  The market gains and declines over that 25 year period of time will average out to a gain down the road.  So you shouldn’t care if you extrapolate the value of the S&P 500 down or up over short periods of time.

Over the long run you know you will have more money than you started with.  Because, if you don’t have more money over that long a period of time, it means the stock market hasn’t increased in value over a 25 year period of time.  And in that case we are all screwed.  But it really would only make you normal screwed, not, I’m a terrible investor and everyone has outperformed me, screwed.  This is because the majority of people have less money along with you, so maybe prices adjust for goods in the future yatta, yatta, yatta.

Better to be screwed along with everyone, than to be the lone terrible investor in a market filled with winners.

photo credit: black.zack00 LIttle devil via photopin (license)