Planning Fallacy as a concept is defined by Nobel Prize winning psychologist Daniel Kahneman and Amos Tversky as the tendency to underestimate the time, costs and resources and the overestimation of the benefits of our tasks.
We tend to the same when it comes to our finances -
- We overestimate our investment skills and our earning capacity.
- We do not think of all possible scenarios of the market.
- We underestimate expenditure and retirement needs.
- We do not save enough.
- We are overconfident of our knowledge many times leading to planning risky investment choices.
- Set your goals and think of your financial future
- Think though different aspects of life and different scenarios
- Set a realistic budget
- Measure your financial progress.
Ensure that you make a comprehensive financial plan either yourself or with the help of professional advice or using financial tools so that you avoid being taken by surprise
How can we avoid the planning fallacy?
Set Realistic Goals – It is good to aim for the stars but you have to be realistic about it. You should assess your investment skills, saving capacity and expenditure and then set financial targets. Look at your actions and decisions in the past and use them as reference to set future goals. For example, if you save Rs. 5000 monthly, you cannot set a target of savings Rs. 15000 overnight. You might be better off setting a target of Rs. 7000. There is a higher probability of reaching the target which will make you self-confident too.
Plan for unexpected scenarios – Your child will need money for an unexpected trip in school. An investment that you thought will beat the market might give you negative returns. You might win a cash prize. It is difficult to think of all such scenarios but you should draft your financial plan such that there is flexibility to tweak it to adapt to different scenarios.
Do Your Homework – Research well. Think of different scenarios – optimistic and pessimistic. Many times you might have made mistakes earlier. Understand where you went wrong and ensure that you are taking care of that in your future plans. Review your financial plan regularly so that you might catch mistakes early on. If you see that your SIPs in equity funds will lead you to be over-invested in equity, reduce the SIPs in those funds or increase the SIPs in debt funds. If you had gone over the budget by 20% while decorating your house a couple of years back, think what line of thought you should avoid while buying and accessorising a new car.
Get Professional Advice – We all may not be investment experts. Some of us may not have time or the inclination to manage our finances. In such cases, it is best to get a professional financial planner who can manage our financial plan.
It is important to avoid such biases so that your financial plan is effective.