Money Fallacy #1: The Checks Will Not Always Come
Money Fallacy #1: The Checks Will Not Always Come
By Darius Foroux
In the world of behavioral science and finance, there’s a concept called “overextrapolation” or “extrapolation bias” which refers to the assumption that past returns equal returns. We also tend to make that same mistake with our income. A lot of people assume their current income level will move in the same direction. If they are earning more every year, they think they will keep earning more. And if they are earning less, they anxiously assume that trend will keep going down.
Both are wrong. A person who earns well today can’t assume the checks will keep coming in (think of all the people who enjoyed 5 minutes of fame). In my latest article, I share how you can avoid this money fallacy.
Money Fallacy #1: The Checks Will Not Always Come
Consider two artists: MC Hammer and Chamillionaire. Most people know the former because he famously went broke in the 90s despite earning millions of dollars. It’s a good case of money fallacy that many people who earn well often ignore.
MC Hammer made 37 million dollars. But he spent 50. And when he declared bankruptcy in 1996, he had 13 million dollars of debt.
Now, look at Chamillionaire, who just like Hammer, was popular for a few years. When I was in college, he had a famous song called Ridin Dirty. I was never a fan and never heard about Chamillionaire again until a few years ago.
I read that used the money he made during those few years he was popular to invest. Now, he’s worth at least 50 million dollars.
Enter: The Extrapolation Bias
In the world of behavioral science and finance, there’s a concept called “overextrapolation” or “extrapolation bias” which refers to the assumption that past returns equal returns (the terms are used interchangeably).
According to one paper by Purdue scientists, Cassella and Gulen, “An extrapolative investor believes that recent high returns are more likely to be followed by high returns, and similarly, recent low returns are more likely to be followed by low returns.”1