Cultural Influences on Financial Decisions
February 12, 2025
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Investors are used to looking at projections of future events. They commonly use projections about future cash flows, future profits, and even future dividends in order to make investing decisions. However, a lot of the time, the projections that they use are overly optimistic. This leads them to make bad investing decisions. This problem of overly optimistic forecasts negatively impacting the portfolio of investors is called the planning fallacy.
In this article, we will understand what the planning fallacy is and how it impacts decision making.
Let us understand the planning fallacy with the help of a very famous example. When the idea of the Sydney Opera House was first conceived, it was estimated that the construction would be completed at the cost of $7 million. However, during the construction of the project, several delays happened. As a result, the project was delayed by over a decade and ended up costing $102 million!
Not all planning errors are as dramatic as the Sydney Opera House. However, the sheer magnitude of the mismatch, in this case, helps in driving home the point. The Sydney Opera House was not an isolated incident. A study of all the rail projects around the world has shown that it is common for more than 80% of the rail projects to drastically overestimate the number of users. This is the reason why the tendency to overestimate everything and present rosy pictures has caught the attention of behavioral finance practitioners. Over the years, they have conducted experiments to prove that this is actually a part of normal human behavior and hence have started calling it the “planning fallacy.”
The planning fallacy has a huge impact on the behavior of individual investors. Some of these effects have been written down below:
The reality is that every investor, be it an individual or a corporation, is somehow affected by the planning fallacy. Meeting the forecast 100% of the time may not be a possibility. However, investors must try to be more accurate.
It is not possible to completely avoid the planning fallacy. However, its impact can be reduced by following certain steps:
The bottom line is that all investors are prone to the planning fallacy. They must make conscious attempts to identify and avoid this fallacy. Like other biases, this can be deeply ingrained, and hence identifying this fallacy may be difficult.
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