The Planning Fallacy

By
Sarah F. Roach

Niels Bohr, Nobel Laureate in physics, famously said, “Prediction is very difficult, especially if it’s about the future.”  Nothing is truer, but at the same time, planning for our financial future necessarily requires certain expectations:  How long will I work?  How much will I earn and in what sequence will my investment returns occur—before and during retirement?  When should I start saving and how much?  And on and on.  It’s not surprising that people tend to answer such questions incorrectly.

One way we commonly make mistakes is called the “planning fallacy.”  As defined by Dan Lovallo and (another) Nobel Laureate, Daniel Kahneman, “the planning fallacy 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.”  At the root of the planning fallacy is our overconfidence in our abilities and our strong tendency to minimize or ignore what might go wrong along the way.  The result is that many projects—from fixing a faucet to building a bridge—take longer and cost more than predicted, and even minor home repairs require multiple trips to the hardware store.  We simply don’t take Murphy’s Law into account, even when a project is far more narrow in scope and time than a decades-long retirement. 

Interestingly, when research subjects were asked to predict various outcomes based on their “best guess” (i.e., realistic) scenario versus their “best case” (i.e., nothing goes wrong) scenario, their responses were practically indistinguishable.  Yet when it comes to planning for retirement, “best guess” and “best case” can be very different.  We tend to misjudge the length and cost of retirement, and when building a nest egg, many people underestimate the effect of choosing low-volatility, lower-return investments—in the name of perceived safety—over higher-volatility, higher-average return investments.

It may sound counterintuitive, but the aspect of planning that most often gets us in trouble is the planning process itself.  We ignore historical precedents and dwell on details that—we think—make our situation unique.  This is referred to as taking an “inside” view.  In contrast, an “outside” view deliberately minimizes the particulars of any given situation and focuses instead on broadly-similar situations and what history can tell us.  In our data-driven world, you might think that considering more detail always leads to better decisions, but studies have shown that when people have less specific information, their predictions are typically more accurate.

So how should investors dodge the planning fallacy and foster an outside view when saving for retirement?  Here are two effective suggestions:  First, revisit your plans frequently to determine if your earlier expectations are still reasonable.  Second, listen to the opinions of outsiders, like us, who have valuable big-picture knowledge to impart.  You may learn that a successful retirement typically requires more money and/or later retirement than you would’ve predicted, and that accepting short-term volatility is far less “risky” than not accumulating a large enough nest egg.  You hired us, in part, for exactly that kind of information, and we’re here to share it.