Spontaneous financial decisions are not always in our best interest. In this series of articles, we will examine the speed vs. accuracy tradeoff that can result in costly mistakes and create behavioral blind spots in our financial planning process.
In this series of articles, we will examine how we are inclined to make spontaneous financial planning decisions that are not always in our best interest. The premise of why we often make bad decisions is rooted in the field of science known as behavioral finance, which combines behavioral and cognitive psychological theory with conventional finance to explain why people make irrational financial decisions.
According to Daniel Kahneman, a renowned economist, psychologist and 2002 Nobel Prize winner, notable for his work on the psychology of judgment and decision making, “The brain doesn’t like logical, rational, conscious thinking—and will take any shortcut it can.”
In essence, there is a speed vs. accuracy tradeoff that creates a costly gap between “what I should do” and “what I actually do.” The result can create a behavioral blind spot (or bias) in our planning process.
Behavioral Blind Spot: Planning Fallacy
An easy way to understand this behavioral bias is to know that we often make plans based on limited, imperfect information. In other words, we overestimate the likelihood or positive future events and underestimate the likelihood of negative future events.
For example, many people say they plan to retire at a later age than they actually do. In fact, statistics show what we often plan to do and what we actually do are miles apart. According to research, 72% of people plan to work to age 65 or later, but in reality, only 24% actually work until age 65 or later.1
The reasons behind such disparity? "Health issues and getting laid off" are cited 60% of the time as the reasons for retiring earlier than planned.2 Yet, interestingly, we often have little control over those issues and would rarely prepare for them. That adds to the disconnect.
The planning fallacy bias can trick you into making decisions and choices that are more emotionally optimistic than factually data based. Because there's so much outside of your control, it's easy to get narrowly focused on what you think should happen and fail to consider all the risks that can come with a big life decision.
How to shine a light on this behavioral blind spot.
- Use the data from people in similar circumstances to help predict your future path. Rather than asking, "What is the right age to retire?" it might be better to ask, "At what age have others in similar circumstances retired?" Start with the average experience and adjust up or down from there based on someone's unique circumstances.
- Conduct a premortem. Ask, "What could take this plan off track?" You have to be a pessimist and fight against your natural optimism to uncover the biggest threats to a retirement plan. This can lead to some uncomfortable conversations around what happens if someone loses their job or suddenly finds themselves in poor health. Addressing the challenging issues can help you plan for the unforeseen.
- Get an unbiased gut check of the plan—it's invaluable. Talk to your financial professional who works every day with clients like you, many of whom may face the same decisions you are with your retirement plan. Your financial professional has helped many people retire and has seen what happens along the path and may be your best source of an unbiased perspective.
We trust this discussion has been helpful for you to understand why we make certain financial decisions and the behavioral influences that can cause those decisions to go awry. Importantly, you are now better equipped to counter those tendencies. In our next article, we will address a second behavioral blind spot known as anchoring bias.