What is Durability Bias?
Durability bias is the tendency to project the recent past into the future. The assumption is that recent trends are likely to continue, which is not necessarily the case. Recent occurrences may have been triggered by one-time events that are unlikely to recur, such as a major order from a buyer for a fashion item.
Or, the billings under a large government contract have nearly consumed the original funding, after which the contract will be terminated. These issues are routinely overlooked by people, who prefer to extrapolate recent sales figures into the future without looking at the underlying trends. The same problem arises with investors, who tend to think that historical pricing for securities will extend into the future.
People can ignore durability bias on both the upside and the downside. For example, a company assumes that rapid sales growth will continue forever, and so makes the mistake of investing heavily in new production facilities to handle additional growth that turns out to never occur. Or, a business mired in a recession is operated in low-cost mode for too long, so that the firm does not have sufficient capacity to service customers when the recession eventually turns around and demand begins to increase.
Implications of the Durability Bias
The durability bias can have a significantly adverse effect on decision-making for investors. To illustrate the point, imagine an investor who believes a company that has regularly outperformed analyst estimates for Earnings per Share (EPS) will continue to do so indefinitely. Imagine then that the competitive landscape in an industry changes, and the company doesn’t alter its business model in response. Over time this company would start underperforming and prove to be a bad investment.
In this example, using the past as a reference for the future was not a good idea. Instead, an investor should look forward to what may happen in the future, independent of the past.
Example of Durability Bias
US markets are seeing significant growth, with stocks yielding unprecedented returns due to a booming market and expanding economy. John is a retail investor and current business student who recently took an interest in investing. He notices the impressive gains in a stock called “CFI,” which has seen a price surge of 15% year-over-year. John concludes that if he invests $10,000 in the stock today, given the year-over-year gain of 15% on the stock, he will end up with $20,000 in five years’ time.
In the example above, John is exhibiting durability bias. He assumes that since the stock of CFI has seen a gain of 15% yearly, it will continue to do so into the foreseeable future. The truth is that the past performance of the stock is not necessarily indicative of future performance.