Beating the Bias: Tips to Avoid the Planning Fallacy

Much like the Montreal Olympic stadium, the Sydney Opera House was a planning fiasco, which many people consider to be the champion of all planning disasters. According to original estimates in 1957, the opera house would be completed early in 1963 for $7 million. A scaled-down version of the opera house finally opened in 1973, 10 years after originally planned, at a cost of $102 million¹ ($95 million over-budget).

There are no shortages of planning disasters, and this phenomenon is not limited to commercial megaprojects. Studies have found that individuals make the same mistakes when planning their private lives. In 2002, a survey of American homeowners who had remodelled their kitchens found that, on average, they had expected the job to cost $18,658; in fact, they ended up paying an average of $38,769². You can probably relate to this if you or someone you know have gone through a major home renovation.

The planning fallacy, as defined by Nobel Laureate Daniel Kahneman and Dan Lovallo, is our tendency to underestimate the time, costs, and risks of future actions while at the same time overestimate the benefits of those same actions. It explains why we overrate our own capacities and exaggerate our abilities to shape the future.

The planning fallacy has direct personal financial implications. Setting overly optimistic financial goals is heroic, but comes with a higher risk of falling short, which can lead to undesirable life outcomes. Governments and big corporations have deep pockets and theoretically an infinite time horizon, which gives them the ability to recuperate from catastrophic planning. But individuals don’t have the same liberties and setting impractical expectations can be detrimental to their financial well-being.

So how do you avoid the planning fallacy trap?

1. Set realistic goals based on past experiences.

It’s good to shoot for the stars, but you don’t want to overextend yourself in an improbable pursuit. If your goal is to pay your mortgage faster, a good indication of your ability to save would be your spending habits. If, in the past, you’ve only been able to save 10% of your after-tax income, it would be unwise to believe that you can save 40% this year without altering your life style significantly.

2. Measure your progress.

Your goals should be measurable. Setting specific goals increases the chance of accomplishment as it allows us to assess our progress towards attainment. “I want to retire in 14 years, with no debt and enough savings to support an annual lifestyle expense of $120,000 indexed with inflation”, is a better way to express your goal, as it is quantifiable, compared to a general goal of wanting to “retire comfortably”.

3. Look at the glass half-empty.

It’s good to see life through the optimist’s lens – that’s what drives us each day. But when planning your financial future, it also helps to look at the worst-case scenario.

At Nexus, we are able to incorporate models such as Monte Carlo Simulations and Scenario Analysis in the financial planning process to map your goals based on a standard group of underlying assumptions. This allows us to make sure you are prepared for a wide range of scenarios, in case life does not go as planned.

4. Take an outside view.

Using information from other planning projects similar to yours being forecasted is called taking an “outside view”. Bert Flyvbjerg, Danish planning expert at Oxford University, considers this approach the single most important piece of advice on how to increase accuracy in forecasting and avoid the planning fallacy.

Interestingly, studies have shown that individuals rely on distributional information when forecasting for others rather than for themselves. Put another way, the planning fallacy vanishes when individuals forecast other people’s task completions³.

Here at Nexus, we believe a personal financial plan helps our clients reach their goals with confidence. We work with you to determine realistic objectives that are quantifiable, and, using planning software, we can assess the probability of meeting goals while allowing for adjustments to stay on track. Most importantly we have the vantage point and the know-how to provide you with an impartial “outside view” to ensure you stay clear of the planning fallacy trap.