One of my favorite podcasts, Freakonomics, recently covered the concept of planning fallacy. The discussion was mostly in the context of project management, which I enjoyed since that’s what I do for my day job. Planning fallacy has wide-reaching implications for our personal finances though, too, and that’s what I want to examine here today.
As you read about planning fallacy, consider the “projects” to be parts of your life — your retirement savings, personal goals, or career progress. Is it taking longer than you expected to reach the milestones you have set for yourself?
What is planning fallacy?
Planning fallacy is the tendency to underestimate the time and cost it will take to do something. The concept was proposed by Daniel Kahneman and Amos Tversky in 1977. If you’ve ever tracked a government project or a construction timeline, you have likely seen planning fallacy in action — those projects seemingly always run late!
It’s easy to poke fun at bureaucratic inefficiencies, but we’re often subject to planning fallacy in our own lives. It’s the reason I’m consistently 7 minutes late to work even though I know it will take me almost exactly 25 minutes to drive there and 5 minutes to walk from my car to my desk.
How much of an effect does planning fallacy have?
In the Freakonomics podcast episode, host Stephen Dubner interviewed several subject matter experts including Tali Sharot (a cognitive neuroscientist at University College London) and Roger Buehler (a professor of psychology at Wilfrid Laurier University).
Buehler conducted a study with his students and found that students predicted that their theses would take, on average, 33.9 days to complete. In reality, it ended up taking 55.5 days, on average — a 64% overage.
Buehler argues that students, though they are often overused in academic studies due to convenience, are actually a particularly relevant population to use for this study since the theses have a clearly-defined timeline and deliverable.
Buehler explained that “…Kahneman and Tversky [make a distinction] between two types of thinking, one being a kind of inside approach and the other being an outside approach… The inside approach involves really focusing on the case at hand and trying to work out the details of that unique case. It’s like you’re developing a mental scenario or mental simulation of how you think that project will unfold.
“But the problem is that mental simulations often don’t provide the thorough and comprehensive representation of how things will go. They tend to often be kind of idealized. Oversimplified. And when people get into that frame of thought, they don’t entertain alternative ways in which things may go.”
Planning fallacy can occur even when you know that there is knowledge and data contrary to your plans. This is what Beuhler is describing when he talks about the “inside approach:” thinking that your situation or project is special, or that your ability to project how things will go is more accurate than what the objective data suggests.
If construction projects seem to always run 50% longer than planned, why can’t construction managers just increase their estimates by 50% so their estimates are more accurate? It’s because they’re taking the inside approach — oversimplified or idealized thinking about how efficient the project will be.
Clearly, planning fallacy is related to an optimism bias.
In the portion of the podcast when Dubner interviewed Tali Sharot, they explained that “the brain tends to process positive information about the future more readily than negative information.”
Optimism bias, and therefore planning fallacy, are both related to how our brains work naturally.
Plus, Sharot explains, optimism bias can actually have benefits in our lives outside of planning. Optimism improves our mental and physical health by helping to reduce anxiety, stress, and depression. So it’s not all bad, but we do need to be aware of optimism’s effect on our ability to plan accurately.
To counteract planning fallacy, consider how an outsider would approach the same project. Ask yourself the following questions:
- How long has it taken you to complete similar projects in the past?
- What are the specifics of the project you are planning? How will that make this project different than past instances?
- What are possible unexpected obstacles? How likely are they to occur and how large of an impact would these obstacles have?
How does planning fallacy and optimism bias affect your your life?
Here are the practical points of application, now that planning fallacy is on your radar.
Take the “outside view.”
Remember that planning fallacy can affect you personally beyond your finances. Evaluate all of your goals and your progress towards achieving them. Is planning fallacy or optimism bias slowing your progress compared to your expectations?
Plan for the future
The only thing worse than having a poorly-constructed plan is having no plan at all.
Think about these questions:
- When would you like to stop working?
- When do you think your health will force you to stop working?
- What does your life look like now? What would you like it to look like ideally?
- How long do you expect to live?
- What upcoming major expenses do you and your family need to account for?
In many areas of personal finance, the best thing to do is to just start! For example, your savings rate is more important than your investments’ returns. It’s more valuable that you are investing at all than it would be to wait to find the optimized mix of everything.
Escape the analysis paralysis. Start your own financial planning today, even if it’s not perfect.
Conservatively estimate your future expenses
When estimating your future expenses, err towards higher estimates. Why? The future is unknown, and that means there is risk.
Health care costs in the U.S., for example, have risen faster than annual income. So you should not assume that health care in your retirement will cost the same as your health care now, or even that it will cost the same as current retiree’s health care costs now.
You don’t want to plan for the future to be all best-case scenarios, because by definition it will very likely not turn out that way.
Conservatively estimate your future income or investment growth
When estimating your future income and investment growth, err towards estimating lower.
Too many people are not saving for retirement now because they feel that their income will rise significantly later in their careers. Then, they think, they will have the money to start saving. This line of thinking is a mistake.
You should also be careful not to count on infeasible investment growth when you are making your retirement plans. Learn about historical returns for a portfolio with your personal asset allocation. Don’t forget to account for inflation.
Remember to plan for future obstacles
Rather than being surprised by emergencies or obstacles in the future, plan for them proactively.
Since I started to be more mindful of planning fallacy in my own life, I am aware that I am victim to it frequently. This is the first step: realize you are being affected.
If you’re really stuck with planning and being overoptimistic, you can always do what the construction workers and college students did not — add 64% to your plans!