{"id":4721,"date":"2024-10-27T18:01:08","date_gmt":"2024-10-27T14:01:08","guid":{"rendered":"https:\/\/eoninvestment.com\/?p=4721"},"modified":"2024-11-13T22:03:23","modified_gmt":"2024-11-13T18:03:23","slug":"representativeness-in-growth-forecasting","status":"publish","type":"post","link":"https:\/\/eoninvestment.com\/ka\/2024\/10\/27\/representativeness-in-growth-forecasting\/","title":{"rendered":"Representativeness in Growth Forecasting"},"content":{"rendered":"\n

Representativeness can heavily influence investor decisions and analyst forecasts. This cognitive bias leads us to assume that past performance will persist, making it a common source of error in growth rate estimation.
Consider this example, shown in the chart below:

1\ufe0f\u20e3 Initial Growth Expectations:<\/strong>
Analysts build portfolios based on long-term earnings growth forecasts. The first two bar for each portfolio reflects the annual growth rate from the previous 5 years and forward looking 5 years estimations (correlated).

2\ufe0f\u20e3 Projected vs. Actual Growth:<\/strong>
The subsequent three bars show the actual growth per annum over 1, 3, and 5 years following these forecasts.

Analysts often assume that companies with strong historical growth will continue on the same trajectory, and conversely, that poor performers will remain so.

Key Observations:<\/strong>

Overestimating Growth Persistence:<\/em>
Analysts tend to project high growth for previously high-growth companies, effectively thinking, “this company has been great, so it will continue to be great” or “this underperformer will always underperform.” This is a clear example of representativeness bias, akin to the well-known Linda problem in psychology.

Ignoring Mean Reversion:<\/em>
Analysts overlook that earnings growth typically reverts to the mean over a 5-year horizon. The base rate of mean reversion is high, meaning that low-growth companies tend to catch up, while high-growth companies often slow down. Despite initial appearances, low-growth portfolios generate nearly as much long-term growth as their high-growth counterparts.

This analysis highlights a crucial lesson for investors: judging a company by its past growth can be misleading. The tendency to ignore mean reversion and place undue weight on historical performance is a mistake many analysts make, but one that can be avoided with a more evidence-based approach.

Sourse: James Montier, Behavioural Investing.<\/p>\n\n\n\n

\"\"<\/a><\/figure>\n","protected":false},"excerpt":{"rendered":"

Representativeness can heavily influence investor decisions and analyst forecasts. This cognitive bias leads us to assume that past performance will persist, making it a common source of error in growth rate estimation.Consider this example, shown in the chart below: 1\ufe0f\u20e3 Initial Growth Expectations:Analysts build portfolios based on long-term earnings growth forecasts. The first two bar […]<\/p>\n","protected":false},"author":12998525,"featured_media":0,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"_coblocks_attr":"","_coblocks_dimensions":"","_coblocks_responsive_height":"","_coblocks_accordion_ie_support":"","_crdt_document":"","advanced_seo_description":"","jetpack_seo_html_title":"","jetpack_seo_noindex":false,"_jetpack_newsletter_access":"","_jetpack_dont_email_post_to_subs":false,"_jetpack_newsletter_tier_id":0,"_jetpack_memberships_contains_paywalled_content":false,"_jetpack_memberships_contains_paid_content":false,"footnotes":"","jetpack_publicize_message":"","jetpack_publicize_feature_enabled":true,"jetpack_social_post_already_shared":false,"jetpack_social_options":{"image_generator_settings":{"template":"highway","default_image_id":0,"font":"","enabled":false},"version":2},"jetpack_post_was_ever_published":false},"categories":[776003142,104753438,20100],"tags":[14650055,4269,6635,13843,8589],"class_list":["post-4721","post","type-post","status-publish","format-standard","hentry","category-behavioral-investing-by-james-montier-ka","category-behavioural-investing","category-growth","tag-behavioral-investing","tag-finance","tag-investing","tag-stock-market","tag-stocks","has-post-thumbnail","fallback-thumbnail"],"jetpack_publicize_connections":[],"jetpack_featured_media_url":"","jetpack_likes_enabled":true,"jetpack_sharing_enabled":true,"jetpack_shortlink":"https:\/\/wp.me\/pQZ85-1e9","_links":{"self":[{"href":"https:\/\/eoninvestment.com\/ka\/wp-json\/wp\/v2\/posts\/4721","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/eoninvestment.com\/ka\/wp-json\/wp\/v2\/posts"}],"about":[{"href":"https:\/\/eoninvestment.com\/ka\/wp-json\/wp\/v2\/types\/post"}],"author":[{"embeddable":true,"href":"https:\/\/eoninvestment.com\/ka\/wp-json\/wp\/v2\/users\/12998525"}],"replies":[{"embeddable":true,"href":"https:\/\/eoninvestment.com\/ka\/wp-json\/wp\/v2\/comments?post=4721"}],"version-history":[{"count":3,"href":"https:\/\/eoninvestment.com\/ka\/wp-json\/wp\/v2\/posts\/4721\/revisions"}],"predecessor-version":[{"id":4725,"href":"https:\/\/eoninvestment.com\/ka\/wp-json\/wp\/v2\/posts\/4721\/revisions\/4725"}],"wp:attachment":[{"href":"https:\/\/eoninvestment.com\/ka\/wp-json\/wp\/v2\/media?parent=4721"}],"wp:term":[{"taxonomy":"category","embeddable":true,"href":"https:\/\/eoninvestment.com\/ka\/wp-json\/wp\/v2\/categories?post=4721"},{"taxonomy":"post_tag","embeddable":true,"href":"https:\/\/eoninvestment.com\/ka\/wp-json\/wp\/v2\/tags?post=4721"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}