The Planning Fallacy

In his terrific new book, Thinking, Fast and Slow, Nobel laureate Dan Kahneman outlines what he calls the “planning fallacy.” It’s a corollary to optimism bias (think Lake Wobegon – where all the children are above average) and self-serving bias (where the good stuff is my doing and the bad stuff is always someone else’s fault). Most of us overrate our own capacities and exaggerate our abilities to shape the future.  The planning fallacy is our tendency to underestimate the time, costs, and risks of future actions and at the same time overestimate the benefits thereof.  It’s at least partly why we underestimate bad results. It’s why we think it won’t take us as long to accomplish something as it does. It’s why projects tend to cost more than we expect.  It’s why the results we achieve aren’t as good as we expect.  Clients and financial professionals are both (all!) susceptible.

In a financial context, it has several particular applications, including the following.

  1. Because we underestimate risk generally and discount future risk too much, we ought to be particularly skeptical about our various estimates of results and outcomes and ought to consider more carefully the consequences if (when!) things don’t turn out as well as we planned.
  2. We should value the benefits of guarantees (when available) more than the benefits of potential.  Accordingly, we should typically be concerned more about the costs of failure than about opportunity costs.  A bird in the hand is worth two in the bush.
  3. We should think about tail risk more.  For example, is a “safe withdrawal rate” that assumes a 5 percent portfolio failure rate over a 30-year time span (longevity risk anyone?) anything like “safe” when the consequences of failure are so high and our willingness to undervalue such risks is so clear?

Another reason why this problem is so acute for advisors is the so-called “authorization imperative.”  Our plans and proposals must be approved by our clients and we have a stake in getting that approval. This dynamic leads to our tendency to understate risk and overstate potential.  Perhaps we see it as easier to get forgiveness than permission or perhaps it’s just a sales pitch.  Or maybe we have convinced ourselves that we’ve got everything covered (confirmation bias!). Either way, despite its strategic benefits, we run the risk of serious misrepresentation. 

Similarly, nearly every advisor works with individuals who say they are risk averse to varying degrees, but typically more risk averse than the advisor would like them to be.  The tendency is then to try to convey to or convince the client that not being aggressive enough is a risk too – the risk of not meeting one’s goals.  The planning fallacy is another reason not to push that approach too far.


21 thoughts on “The Planning Fallacy

  1. Pingback: Wednesday links: an arbitrary concept | Abnormal Returns

  2. Pingback: The Five Biggest (Non-Investment) Mistakes Retirees Make | Above the Market

  3. Pingback: Education and Intelligence Can Make Things Worse | Above the Market

  4. Pingback: Happy Blogiversary to Me | Above the Market

  5. Pingback: The Missing Lead | Above the Market

  6. Pingback: Neurath’s Boat | Above the Market

  7. Pingback: A Disaster Waiting to Happen | Above the Market

  8. Pingback: Midweek AM Reads | The Big Picture

  9. Pingback: Sunder's List: Uncertainty - StockViz

  10. Pingback: Mid-Week LinkFest | Intellectual Entropy

  11. Pingback: Too Sure By Half | Above the Market

  12. Pingback: Chaos is a friend of mine | Above the Market

  13. Pingback: Should We Pay the Shakedown Artists or Not? | Above the Market

  14. Pingback: Should We Pay the Shakedown Artists or Not? | Thought Equity

  15. Pingback: Beating the Bias Trap (Additional Resources) | Above the Market

  16. Pingback: The Maleficent 7 | Above the Market

  17. Pingback: Math is Different | Above the Market

  18. Pingback: Behavioral Finance: a (Mostly) Musical Revue | Above the Market

  19. Pingback: That was Then, This is Now | Above the Market

  20. Pingback: Top Ten Behavioral Biases, Illustrated #7: Planning is Guessing (the Planning Fallacy) | Above the Market

  21. Pingback: Nobody Really Knows | Above the Market

Leave a Reply

Fill in your details below or click an icon to log in: Logo

You are commenting using your account. Log Out /  Change )

Twitter picture

You are commenting using your Twitter account. Log Out /  Change )

Facebook photo

You are commenting using your Facebook account. Log Out /  Change )

Connecting to %s