behaviour
Straight-line extrapolation
The rule
We assume whatever is growing will keep growing at the same speed forever, in a straight line. But growth bends.
Where it flips
Now and then a real, lasting edge does grow for a long time; the mistake is assuming it by default. Where it misleads: you price a bend as a straight line. The fix: ask what must stay true for the run to continue, and how often it actually does.
Give people a few years of fast growth, and they draw the line straight up. Then they pay for that line today. But growth bends. Rivals arrive. Big numbers are harder to keep doubling. Cycles turn. The straight-line habit is what lets a lovely recent run get priced as if it will last forever.
A worked example
A company grows its profit 40% a year for three years. So the price bakes in 40% for the next ten years. Then growth fades to 12% as rivals pile in. The buyer who paid for the straight line loses money. [illustrative]
How to spot it
- ·the recent growth rate stretched far into the future
- ·no room left for rivals or the cycle
- ·a price that only works if the growth never slows
Behavioural finance research · Behavioural finance research