Have you read about that flyover in your city which was supposed to be completed in 2010 but is yet to get completed? There are several such projects in India and abroad. India’s Ministry of Statistics and Programme Implementation says that as many as 340 infrastructure projects, each worth Rs. 150 Crore or more, have shown cost overruns to the tune of over Rs. 3.3 Lakh Crore owing to delays and other reasons. There are no shortages of planning disasters, and this is not limited to infrastructure mega projects. Studies have found that individuals make the same mistakes when planning their financial lives.
For example, when you plan the budget to buy a house, you might tend to overlook costs associated with making the house livable. This will include the cost of wardrobes, furniture, consumer appliances, club membership charges, association charges, etc. You might end paying more for the house than you had planned for. Understand that Governments and big corporations have deep pockets an infinite time horizon, which gives them the ability to recuperate from catastrophic planning. But individuals don’t have the same liberties.
This is the planning fallacy!
The planning fallacy was defined by Nobel Laureate Daniel Kahneman and Dan Lovallo. It is the tendency to underestimate the time, costs, and risks of future actions and overestimating the benefits of those actions. It explains why we often overrate our capacities and exaggerate our abilities.
The planning fallacy has direct personal finance implications. For instance, setting overly optimistic financial goals comes with a higher risk of falling short. For instance, when you are planning your retirement fund, you might underestimate the expenses for treatments, insurance, tax payable and the inflation rate. You might need to plan on how you can reduce expenses. Even though expenses in the form of children’s education or loan repayments might reduce, expenses related to medical reasons, domestic help, travel, and commute might increase with old age. For example, you may not be able to walk to all places and might use taxi services more often.
Here are other planning fallacies. Sometimes, we overestimate our investment skills and our earning capacity and do not think of all possible scenarios of the equity market. We do not save enough because of overestimating our savings. We might be overconfident of our knowledge leading to risky investment choices.
This leads to poor finances and an imbalance in your investment portfolio. As you can see, the planning fallacy has serious implications on our personal finances and can jeopardize our financial future.
How to avoid planning fallacy
You can avoid the planning fallacy by having quantifiable and realistic goals. Ensure that you stay on track and have an impartial view of events using your past experience. You can take the help of professionals to steer you away from planning fallacy. Here are the steps that you can take.
Have a financial plan
A financial plan will help you
- Make financial goals and think of your financial future
- Consider different events of your life and different market scenarios
- Set investment return expectations
- Measure your financial progress
Ensure that you make a comprehensive financial plan. You could do it yourself or with the help of professional advisers.Learn how to mange your money & create wealth, Download your FREE eBook now
Set realistic goals
While it is good to expect high returns from your investments, have realistic expectations based on the market scenario. Consult with a financial adviser like MoneySage to understand whether your return expectations are realistic. You can do that for other goals. For instance, if your goal is to pay your home loan faster, look at your spending habits to see how you can repay your loan every month. If in the past, you have been able to save only 10% of your after-tax income, you can’t make that 40%. You should first start saving more and then repay your home loan.
Measure your progress
Try and quantify your goals. Setting specific, quantifiable goals increases the chance of accomplishment as it allows you to assess your progress towards attainment. For instance, let’s say you want to save money for your child’s education. Estimate the amount of money you will need and calculate how much you need to save every month to achieve that goal. So, your goal should be to “save Rs. 25 Lakhs for your child’s education” rather than “saving enough for your child’s education”. You need to do this for all your goals.
Also read: How Procrastination Affects Your Finances
When you are planning for your goals, discuss with your peers about how they are approaching the goals. Talk to them about the investments that they want to consider for achieving the goals. This will give you a perspective about how good your plan is. This will increase accuracy in forecasting and avoid the planning fallacy too.
Plan for unexpected scenarios
It could a job loss or medical treatment for a parent. An investment that you thought will beat the market might give you negative returns. It is good to plan for contingencies. Always have a contingency fund along with your goals. Save for this fund first before saving for your financial goals.
Do your homework
Before you start saving for financial goals or planning for your financial future, you should do some homework. Start reading about investments. You can take the help of books, newspapers, websites, and blogs. Instead of blindly following news and tips for investment, read up and enhance your knowledge of personal finance and the economy. You can look at past data and broaden your perspective of the world to understand what works and what does not work.
Review your plan regularly
Regular reviews will help you determine the progress you are making towards your goals. It will also help you understand how different events in life be it marriage or a bonus have affected the plan. If you are deviating from the plan, you can make course corrections. It is important to tweak the plan to suit the current situation. A higher standard of living, under performing investments, need for more insurance, etc. will need you to change your financial plan.
Learn from mistakes you might have made earlier. Understand where you went wrong and ensure that you are taking care of that in your future plans. Reviewing your financial plan regularly will help you catch mistakes early on. For instance, if you see that your SIPs in equity funds are not performing well, you can look at whether you need to switch funds.
Get Professional Advice
All of us may not be investment experts. Some of us may not have time or inclination to manage our finances. In such cases, it is best to get professional help to manage your financial plan. This will save you time and effort and it will help you minimize risks while maximizing your profits for your portfolio.
An adviser like Mymoneysage can help you to determine realistic objectives that are quantifiable , it can help assess the probability of meeting your goals while allowing for adjustments to stay on track. Most importantly Mymoneysage provides you with impartial advice to ensure you stay clear of the planning fallacy trap.