What is Planning Fallacy and how it affects your finances?

If you think Planning Fallacy is only related to Financial Planning – you are wrong. Check why do we fall prey & how to avoid planning fallacy – in this post.

The initial deadline for the Navi Mumbai Metro Rail link was December 2014. Three extensions later, the current deadline has been set for December 2017. The delay has led to an increase in the cost from Rs.1,985 crore toRs.3,000 crore!

HealthCare .gov is the health insurance site operated by the U.S. federal government for people to buy private health insurance and getting subsidies if they are within a certain income level. The estimated cost was USD 93.7 million and the actual amount spent on it was USD 292 million.

These are big projects that have the support of the best expertise and government. But they failed. As you can see, the planning and execution in these cases are not aligned. These projects have not been successful as planned due to the planning fallacy.

Check – Holding Cash – Are You Holding Too Much of It?

What is Planning Fallacy

As defined by Nobel Laureate Daniel Kahneman and Dan Lovallo,

“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.”

We as individuals also fall to planning fallacy. We often overrate our abilities and skills – this can affect our personal finances. We set unattainable goals, believe that we know how to make investment decisions or overestimate our earning capacity. This can lead to problems in our financial life.

My Example 🙂 When I got an opportunity from CNBC to write my “Financial Life Planning” book – they asked when I will submit. I did a rough calculation based on my experience on TFL blog – 6 Months. It took me almost a year to finish that.

Why do we fall prey to planning fallacy?

When we plan or asked to estimate the time or cost to do a task, we visualize the event to happen just like we plan it or rather we expect it. We do not think of delays or unexpected scenarios. In this case, usually, the planning falls short of execution.

In the book, ‘The Art of Thinking Clearly‘, Rolf Dobelli, has said that we usually overestimate what we can do and underestimate costs and risks. We should avoid such wishful thinking.

For example, when we plan the budget to buy a house, many of us overlook costs associated with making the house livable (civic amenities), club membership charges, security charges etc. This can lead to heartache later when we have to pay more and also mess up the budget.

Similarly, when we are planning our retirement fund, we might underestimate medical expenses claiming that we are fit or tax payable assuming that our retirement income will be close to nothing. We might underestimate the inflation rate. We might plan for reduced expenses. Yes expenses in the form of children’s education or loan repayments might reduce. But on the other hand, expenses related to medical reasons, domestic help and travel and commute might increase with old age. For example, you may not be able to walk to all places or use taxi services more often.

Now for the million dollar question –

How to avoid Planning Fallacy?

Here are some methods that you can follow to avoid falling into the trap of the planning fallacy –

1) Learn from mistakes – All of us have made planning mistakes. We either underestimate the time for a task or the cost. It could be something like reaching for a meeting on time or estimating the cost of hospitalization. It is best to keep in mind what we planned and what we did not consider while planning – no taxi available, underestimating the number of days to get discharged from the hospital, or assuming a lesser number of medicines while in hospital etc.

2) Use software/ professional advice while planning finances – All of us do not have the time, energy or inclination to plan our finances meticulously on our own. It is best to leave it to the experts. We can use software tools for budgeting, investment portfolio, and many other personal finance tasks. The other option is to utilize the services of a professional financial planner who will build an investment portfolio for you depending on your goals, current financial situation and a realistic view. For example, if you have been saving 5% of your income every month, you cannot suddenly start saving 25% from the next month and so you cannot increase your estimated expenses to any amount. It has to be realistic.

3) Bring in discipline – Discipline is a quality that we can use in all aspects of life. Instead of blindly following news and tips for investment, we can read up and enhance our knowledge of personal finance and the economy. We can look at past data and broaden our perspective of the world to understand what works and what does not work. This will help us to plan ahead.

4) Review your plan regularly – It is advised to have regular medical health check-ups so that any ailments can be detected early on. Similarly, it is important to review the financial plan regularly.

This helps to determine the progress and how different events in life be it marriage or a bonus have affected the plan. If the plan has been significantly affected, the goals might be affected. Then it is important to tweak the plan to suit the current situation. The standard of living, bad performing investments, insurance needs etc. can change necessitating a change in the financial plan.

We can avoid the planning fallacy by having quantifiable and realistic objectives and taking steps to ensure that we stay on track. Having an impartial view of events, using past experience and appropriate use of professional tools and advice can steer us away from planning fallacy.

If you liked this post must share with your friends. I shared my Planning Fallacy – will love to hear your story in the comment section.