The left tail in our increasingly volatile world

In my previous post I proposed the hypothesis that availability bias explains why most people misidentify the shape of their relationship between their financial situation and their financial wellness.

In the next series of posts I’m going to dive a little bit deeper into either side of that relationship. This post is going to focus on the left hand side of the graph and talk a bit more about volatility and its impact on our finances and lives.

First let’s revisit that graph from my original post outlining our quantitative theory of financial wellness. I want us to focus exclusively on the left hand side highlighted by the red box.

Remember, the light blue line highlights the linear relationship belief we disproved previously, whilst the dark red light highlights what our model tells us actually happens in reality.

This precipitous drop off in the red line illustrates that our financial wellness is much more sensitive to negative changes to our financial situation than we believe. The more volatility we encounter in our financial situation on this side of the graph the more precipitous the impact on our wellness. For instance, seemingly small changes - owing taxes instead of getting a refund -? can have an outsized impact on our wellness.

Why does this matter? We think it matters for three reasons.

The first reason is because it shows the structural blindspot we all face when making money decisions.

As we’ve highlighted previously we all suffer from the availability heuristic. This leads us to make everyday money decisions based on the belief that things will stay roughly the same. When we take out a loan or skip building that rainy day fund we’re making an implicit bet against a negative change to our financial situation - in effect we’re betting against (or “selling”) volatility.

Most of the time it works out fine - we receive the “premium” of an additional line of credit or the extra night with friends - and nothing bad happens. But the universe gives you a premium for selling volatility for a reason, and that one time it doesn’t work out you suddenly understand why…

The second reason is because almost the entire consumer finance is set up to take the other side of this exchange.

When a bank offers you a loan or a credit card they are in effect buying volatility - betting that your situation will change. This may seem counterintuitive, but in reality it’s one of finance’s dirty little secrets that most companies make a large part of their money from consumers who get themselves into trouble.

The reason they can do this is because they have a structural advantage over us: Gigantic balance sheets that can flex and stretch to absorb a spike in volatility. Whilst we’re running around trying to make ends meet, they leverage their balance sheet to breathe in the heightened volatility whilst breathing out increased premiums for us.

It’s important to state that this is not an invective against the consumer finance industry. Yes, there’s been many examples of not treating customers fairly, but most of these can be chalked up to the strange incentives at play in the market. These are businesses after all and need to generate profits for their shareholders.

However, what it does do is illustrate how important it is for us to take time to reflect on money decisions before we enter into an agreement with a buyer of volatility. The ability to borrow money at the click of a button is an incredible innovation, but as with any innovation it’s important to fully understand the connotations arising from it.

The third reason is a powerful trend that’s been underway in our societies over the past? decades.

Its impacts have been written about extensively elsewhere so I’ll just state some direct facts: Inflation adjusted, we're paying 45% more for our rent and 73% more for our house purchases than our parents did in the 1960s. For those of us choosing to go to college it’s even worse, with us paying 129% more than people did in the late 80s. Affordable healthcare, childcare or being able to buy a home and bring up a family on a single salary are just pipe dreams for most of us.

How does this relate to volatility? Simply put things like affordable housing, healthcare, education etc. constitute the basis of the “common good” - in effect our massive societal balance sheet - and create the natural safe space and resilience for us when volatility spikes. Over the past decades - and especially since 2008 - this balance sheet has systematically corroded such that more and more of us are falling off it.

In our model this trend shows up most acutely in the steepness of this left tail.

We hypothesize that if we plotted this relationship for an average American in 1992 this left tail would still be concave in shape, but far more gradual. Sure, for our 90s friend an unexpected medical bill would be an annoyance, but it wouldn’t necessarily mean destitution in the same way it can for those of us living in 2022.

We are stating the economic facts, and how it impacts our individual financial situations. Whatever your political persuasion and your view on the causes or solutions to this situation, we can all agree that as a generation we’re more exposed to volatility than our parents’ generation.?

It’s therefore incumbent on us to equip ourselves with the tools and skill sets required to mitigate this exposure. Yes the curve is steeper and the impact greater, but the knowledge and expertise to counteract it is also more accessible than ever before. To truly take back control of our finances and achieve our happiest, most-fulfilled lives we must unwind this short position and ensure that we’re fully hedged against whatever our increasingly volatile world can throw at this side of the graph.