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.

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