It isn’t very hard to come across stories of people who thought they had everything planned out, only to see everything come apart at the seams. They lost their job. Their car fell apart. Their apartment building burned to the ground. They got sick. Their child or spouse got sick. Someone stole their identity. They got a new boss who turned out to be psychotic.
Quite often, this unexpected change completely derailed their plans. They had to default on debt because of this change. They were unable to pay their other bills. Their work performance declined drastically.
It’s pretty much the same story every single time. Someone has a great plan for their future and can see how they’re going to achieve their big goal. Then something unexpected happens. At the first sign of trouble, their plans fold like an accordion.
If you spend much time looking around at the stories of others, it’s easy to see that the road to your financial goals is likely to not be a smooth one. You’re going to have bumps. Things aren’t going to turn out quite like what you hoped.
Yet, whenever we set up our own financial plans, we believe the path will be smooth and usually plan that way.
Let’s say you owe $1,000 and you can pay back $100 of it each month based on how things are right now. It’s completely normal to expect that the debt will be gone in ten months.
Let’s say that you plan on finishing your degree in two years and then using that to quickly get a better job. It’s completely normal to expect that three years from now you’ll be in a far better situation.
So many of our plans rely on everything running smoothly. Regardless of all of the evidence to the contrary that personal plans don’t go quite like we expect, we still think that once we have that plan in place and start down that path, we’ll walk right to the finish line.
It’s called an optimism bias. We all have it. From Wikipedia’s explanation:
The optimism bias (also known as unrealistic or comparative optimism) is a bias that causes a person to believe that they are less at risk of experiencing a negative event compared to others. There are four factors that cause a person to be optimistically biased: their desired end state, their cognitive mechanisms, the information they have about themselves versus others, and overall mood.
In our minds, we minimize the risk of bad things happening to us. Because of that, we visualize a plan with far less contingencies than we should. Because of that, when disaster strikes, we’re unprepared.
It’s because of the optimism bias that having an emergency fund makes a lot of sense. Since we’re very bad at seeing the things that could disrupt our plans, an emergency fund is just a chunk of money that takes care of many of those things that we can’t visualize. Without it, a bad event can easily knock the wind out of our sails. With an emergency fund, we can quickly handle bad events that might have otherwise wrecked our plans.
It’s because of the optimism bias that the “debt snowball” makes a lot of sense. A “debt snowball” simply means that you pay off your debts in order of balance, starting with the smallest one, and you make all extra payments toward the one with the smallest balance. If you start off paying down the smallest debt first, you’re maximizing your likelihood of getting at least one debt paid off before something derails your plans. Without achieving that sense of success, it becomes very hard to recover and return to the plan after an unexpected event.
It’s because of the optimism bias that we often make unrealistic plans. We’ll envision the straightest possible path to our goals and then wonder why we don’t make it there – or bury ourselves in stress trying to achieve it. A much better approach is to look for real stories of what other people went through and base our plans around authentic ups and downs.
Optimism is a great thing. It can keep us moving when the chips are down. Unfortunately, it can also have the opposite effect – it can cause us to make unrealistic plans and avoid simple steps we can take to avoid those fallbacks. Here are three simple things you can do to minimize the optimism effect in your own planning.
First, have an emergency fund. Always. If you are facing a ton of high-interest debt, build up a $1,000 emergency fund before tackling the debt. If you’ve got some breathing room, make that emergency fund bigger – a few months’ of living expenses sitting in cash in your savings account.
Second, have insurance. If there’s a situation that would be disastrous in your life, like the death of a spouse, have insurance to protect yourself against that outcome. Term life insurance policies are a good first step. Renter’s insurance, if you’re in a rental situation, is another great step.
Third, put breathing room into every plan. Don’t make a plan that completely falls apart if an unexpected event happens. If you’ve committed to a debt repayment plan, make it so that on a normal month, you can actually get ahead of your planned pace. That way, if a bad month happens, you’re still on pace overall. Every plan needs some breathing room.
Optimism is great. Optimism is powerful. However, it doesn’t mean you’re infallible. It doesn’t mean that things you don’t expect won’t come crashing into your life. Make your plans as though at least a few unexpected things will happen and you’ll find yourself making much better progress toward your goals.