Before understanding how planning fallacy can affect your finances, you must first know what a planning fallacy is. The planning fallacy is the underestimation of time, costs, and risks. It applies to our daily lives in many ways than we can think of.
You can relate several daily life events to the planning fallacy. When you are going to meet a friend, you could tell her that you will reach in 30 minutes. However, there could be traffic on the way, and you could end up reaching after 75 minutes.
Another example that is most relevant in the current scenario could be that you have ordered for a product online. Upon placing the order, the app stated that you would receive your product in five working days. Due to the complete lockdown scene in India, your package has not been shipped yet and will not be delivered for an uncertain time. Therefore, the planning fallacy may occur due to ignored or unforeseen circumstances.
The planning fallacy is not a concept that applies only at a personal or business level. It could happen with governments as well. When it comes to Mumbai Trans Harbour Link, the country’s longest sea bridge at 22.5 km, the government aimed at connecting the eastern suburbs of Mumbai with the mainland across the harbour through a 16.5 km sea bridge and a viaduct.
The estimated cost of the project was Rs.18,000 crore when Prime Minister Narendra Modi laid the foundation stone in December 2016. The project was expected to complete by 2019. However, the latest reports state that the first girder of the project was inaugurated in January 2020. The overall project is expected to complete by 2022. Taking a count of the labour and machinery cost incurred over the three additional years will shoot out the estimated cost drastically.
Such fallacies, when they occur in our financial lives, can be disastrous. But why do our financial plans go haywire? Here’s the answer:
- We overestimate our earning capability.
- We oversee the possible variations of life.
- We underestimate the expenditure and the need to make retirement plans.
- We do not save enough money.
- We are overconfident of our knowledge about the market and end up making risky investment choices.
This is how we strike an imbalance in our investment portfolio and see a downfall. We take count of only the planned expenses without giving space for the unplanned expenses and let our plan go for a toss. Therefore, it becomes essential for us to take the necessary precautions so that there is minimal room for our plans to fail.
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- Plan for the unexpected:
A family member may get a health disorder that is not covered by your insurance policy. A business trip may unexpectedly take the form of a family trip. Your company may want to downsize and think you are no longer required. Or, on the positive side, you may win a cash prize, get a promotion, or your kid gets an opportunity to study abroad. Your financial plan must be flexible enough to take in any surprises—positive or negative.
- Do your research:
Research about the financial instruments you are considering. Talk to a friend your trust and find their first-hand experience dealing with those instruments. Recall what caused your previous years’ business plans to fail and take care not to repeat them. Pull out information from every source possible before you invest in anything. - Set realistic goals:
You must understand the current market scenario and have enough knowledge to predict the market variations over the next few years. Then, you will be all-equipped to set realistic goals. Also, you must ‘accept’ your spending habits and the commitments you have to figure out your ability to invest.
When you know you are a shopping-freak, you can’t promise to yourself that you will stop unnecessary expenditure so that you can invest a higher amount. This turns out to be unrealistic because, after a few months, you will go back to shopping mode! - Get help from professionals:
Since all of us are not experts in terms of investment planning, you can get advice from professionals. They can help frame an effective investment plan for you or validate the project you have designed. They know much more on the matter than we do. You could get maximum profits and encounter fewer risks on the path. - Keep track of your progress:
You must set some quantifiable goals to keep track of the development as compared to your overall goal. If your goal is to save Rs.70 lakh to purchase a house, you must break the goal into smaller bits such that you know how much you must save for the down payment every month. At any point in time, you must know how much you have saved and the remaining time/money required to achieve your goal. - Review your plan regularly:
It is very crucial to review your policy once in a while, say once a year. Again, consider the example of saving up for down payment of a house. You might have planned to save up for three years to gather the required down payment. However, real estate rates might have seen a hike by the end of the second year and following your plan may not give you the needed sum. Therefore, you must re-design your plan so that you save up a more significant quantity for the next year to reach your goal. Otherwise, you may have to push the plan for the fourth year while putting together the same amount.
When you plan considering all the uncertainties and keep your plan flexible, it is possible to keep the planning fallacy minimal. Time to re-look at your financial plan?
For any clarifications/feedback on the topic, please contact the writer at apoorva.n@cleartax.in
