The tenacity of our linear fallacy

In my previous post covering our quantitative theory on financial wellness we illustrated how most people labor under the mistaken belief that a linear relationship exists between their financial situation and their financial health: Essentially that as they gain or lose money there is a direct, proportional increase or decrease in their financial wellness.

In that post we revealed that belief to be a fallacy and provided an alternative model corroborated with events we witness in the real world.

However, this original fallacy remains stubbornly persistent in most people’s general conceptual framework around money. Why?

More research needs to be done in this area but I'd like to walk through our working hypothesis.

Let’s take our graph from the previous post that illustrates the perceived linear relationship (light blue) versus our modeled reality (dark red).

We can see how, as we move further away from our current financial situation, the divergence grows between what we perceive the impact of a change on our financial wellness will be versus the reality.

The events at these “tails” of the graph are things such as losing our jobs or receiving a significant windfall - events that we experience rarely in our lives. They represent high-impact but low-probability changes to our financial situation.

So let’s adjust the scale of our graph to clip these low probability tail events and include only the type of changes that people experience on a regular basis - things like a gradual increase in our income or small increase in our utility bills.

Now suddenly the gap between the perceived linear relationship versus the (modeled) reality has shrunk considerably. To a person who lives primarily in this high-probability but low-impact world the divergence between the original linear fallacy and our more accurate model will seem minuscule.

As humans we’re well known for our predisposition to the availability heuristic - the concept that we judge the probability of an event occurring based on our most recent experience rather than any rational analysis of its genuine likelihood.

If we live most of our lives in this narrow window of experience is it any wonder that we project that experience linearly to what lies outside of it?

But this misprojection creates real problems for us. It means we materially underestimate the impact of negative events whilst materially overestimating our preparedness to take advantage of positive events.?

Lots of words have been written on the material underestimation of the impact of negative events. For instance it's regularly reported that even after 3 rounds of COVID stimulus payments 165 million Americans (51%) still don’t have enough savings to cover 3 months worth of expenses.

But less has been written on the negative impact of materially overestimating our preparedness to take advantage of positive events.?I’ll be writing more on this side of the graph in future posts, but to whet your appetite I’d like to leave you with one of my favourite statistics for illustrating the challenge here: You’re actually more likely to declare bankruptcy within 3-to-5 years if you win the lottery than if you don’t.