The Planning Fallacy

Investors are used to looking at projections of future events. They commonly use projections about future cash flows, future profits, and even future dividends in order to make investing decisions. However, a lot of the time, the projections that they use are overly optimistic. This leads them to make bad investing decisions. This problem of overly optimistic forecasts negatively impacting the portfolio of investors is called the planning fallacy.

In this article, we will understand what the planning fallacy is and how it impacts decision making.

What is Planning Fallacy?

Let us understand the planning fallacy with the help of a very famous example. When the idea of the Sydney Opera House was first conceived, it was estimated that the construction would be completed at the cost of $7 million. However, during the construction of the project, several delays happened. As a result, the project was delayed by over a decade and ended up costing $102 million!

Not all planning errors are as dramatic as the Sydney Opera House. However, the sheer magnitude of the mismatch, in this case, helps in driving home the point. The Sydney Opera House was not an isolated incident. A study of all the rail projects around the world has shown that it is common for more than 80% of the rail projects to drastically overestimate the number of users. This is the reason why the tendency to overestimate everything and present rosy pictures has caught the attention of behavioral finance practitioners. Over the years, they have conducted experiments to prove that this is actually a part of normal human behavior and hence have started calling it the “planning fallacy.”

How the Planning Fallacy Affects Investment Behavior?

The planning fallacy has a huge impact on the behavior of individual investors. Some of these effects have been written down below:

• Smaller Investments: It is because of the planning fallacy that investors make smaller investments in the earlier years of their investing. This is often because their forecasts of the future returns are overly optimistic. Hence, they set aside a smaller share of the money required in order to fulfill their goals and end up spending more on their present-day needs.

• Less Time: It is also common for investors to start investing late because of their planning fallacy. Often they believe that they are too young and that they have a lot of time to make investments. This often causes them to lose valuable time, which has a disproportionate effect on their portfolio. This is because of the compounding effect. People who invest smaller sums of money for a larger period are able to obtain a higher rate of return.

• Discounting External Factors: Investors often assume that they are living in a perfect world. This means that they do not plan for contingencies. They do not plan for the fact that they might face a job loss or may fall sick, and this may affect their investments too. Hence, the reality often turns out to be very different as compared to their estimates. The planning fallacy is one of the biggest reasons why so many people have to go into their retirement with insufficient funds.

• Difficult to Estimate Small Factors: Lastly, the planning fallacy causes investors to miss out on smaller factors. When they are planning, they often tend to look at the big events which could impact their investment decisions. However, a number of small factors can also severely change the course of the projections. Investors need to be mindful of the cumulative effect that a lot of small changes can have on their portfolios. For instance, they might miss their income target by 10%, and expenses may go up by another 10%. Hence, the cumulative negative effect on the savings would be 20%. Over the years, this could mean that the size of their portfolio will reduce by 50% because of the compounding effect.

The reality is that every investor, be it an individual or a corporation, is somehow affected by the planning fallacy. Meeting the forecast 100% of the time may not be a possibility. However, investors must try to be more accurate.

How to Avoid the Planning Fallacy?

It is not possible to completely avoid the planning fallacy. However, its impact can be reduced by following certain steps:

• Use the Past to Predict the Future: Investors must use the past as a predictor of future events. This is because the past often gives a more realistic picture of what is likely to happen, whereas the future projections can be too optimistic and out of sync with reality. Obviously, some adjustments can be made to derive future valuation based on how incomes and expenses are expected to change.

• Consider Setbacks: Another way to avoid the planning fallacy is to ensure that the top two to three setbacks are deliberately included in the planning process. By doing so, the investors make a more realistic forecast. Job losses, illness, and other adversities are part of normal life and hence should be accounted for.

The bottom line is that all investors are prone to the planning fallacy. They must make conscious attempts to identify and avoid this fallacy. Like other biases, this can be deeply ingrained, and hence identifying this fallacy may be difficult.