Use Extrapolation to Help You Not Hurt You

One of the most dangerous things you can do when investing is extrapolate. “Hey, Tesla is up 800% in a year – it’s going to keep going!!” Extrapolation hurts you because a. past returns don’t predict future returns and b. these types of returns are unsustainable. Let me demonstrate.

FAAMG (Facebook, Amazon, Apple, Microsoft, and Google) are up 64% the last year. These stocks are now 18% of the value of all stocks.

So let’s BUY right!? I mean, these companies are everything and amazing and blah blah blah. Well, let’s see what happens over time if they continue to outperform.

Below I graph the percentage of the value of all stocks these 5 companies would represent over time assuming they a. return 64% per year, b. Return 30% per year, or c. Return 20% per year. I assume the stock market returns 12% per year.

You can see how this analysis can save you. In *5* years, these stocks would be worth more than the total stock market (that means the other stocks would have a negative equity value which can’t happen).

Even at 30% per year, this issue would happen in 12 years. At 20% per year – doesn’t sound like much right? – in 25 years they would be worth the entire stock market and then some.

This won’t happen. These stocks may not underperform, but certainly they wouldn’t outperform over time. It’s just not possible once you get to a certain size.