How to Overcome Projection Bias with Your Finances

One of my favorite exercises for planning ahead for the future is for people to make a detailed picture of what their future will look like. It’s a practice I do all the time.

In that practice, I just sit down and think about the future I’d like to have five years from now (or ten or twenty or whatever my timeframe is) in as much detail as possible. I make the assumption that things will go well, but not unbelievably well. It usually incorporates some significant degree of success on the goals I’m working on.

That type of visioning has a few powerful purposes. The biggest one is to somewhat clarify what goals are most important to me, because success with those goals tend to be the first elements I think about in that vision. A secondary benefit is motivation, because I’m visualizing a great outcome to a goal.

Still, there’s a pretty big problem underlining this practice, and that problem has a name: projection bias.

Projection bias is pretty simple to understand. When people think ahead to their future, they often make a ton of assumptions that center around their life being pretty much exactly the same as it is right now. This heavily extends to their current emotional state – if you’re upset, your projection of the future will have a negative tinge to it. If you’re happy, your projection of the future will have a positive tinge to it.

Wikipedia offers a solid explanation:

Projection bias is the tendency to falsely project current preferences onto a future event. When people are trying to estimate their emotional state in the future they attempt to give an unbiased estimate. However, people’s assessments are contaminated by their current emotional state and thus it may be difficult for them to predict their emotional state in the future an occurrence known as mental contamination.

In other words, we tend to visualize our future self as being much like the person we are now, with similar preferences and interests, but that visualization is often strongly tinted by our current emotional state.

So, if making a detailed picture of your future is shaded both by your current preferences and by your current emotional state, what value does that picture have? I argue that a detailed picture still has a lot of value, but there are a few caveats that should be attached to it.

First of all, you should make projections for the future on a regular basis, not just once. If you make a picture of what your future looks like just once and then try to stick with it over time, you’re going to find yourself working toward a future that probably isn’t really what you want, and it’s a picture of the future that you’ll gradually drift away from over time.

Instead, you should visualize the future in detail regularly. This corrects both for your emotional state as well for your other changing preferences in life.

For example, let’s say I’m visualizing the future when I’m in a mood where I feel like my relationship with one of my children is a bit strained, as I had to take away a privilege from them due to some behavioral problem and they got really upset. That feeling will probably have an impact on my vision for the future, even if I’m aware of it.

It’s a bad idea for me to bank all of my plans on that vision of the future. It’s not going to be very accurate in terms of my likely relationship with my child at that point.

Instead, what I should do is re-visualize the future on a regular basis. I do it about once a month, where I write down all of the details I can think of about where I want my future to be headed. The actual goals I’m working toward are something of an average of those visualizations over the last year or so. If there are consistent threads that show up over and over again, I know those are important to me. However, if something pops up only once or twice, I know those things are probably just tied to my emotional state and my focus at the moment.

In terms of specific, concrete plans, stick to what you know will happen. You know that you’re going to get old and you know that there will come a point when you physically and mentally don’t want to work at your current job, so plan for that. You know that your children are going to grow older and you know that, no matter what career path they might choose, they’ll probably need at least a little financial help with the education needed (whether it’s a trade school or a community college or a university). You know that you’re going to eventually have to replace your car. Those things are about as guaranteed as possible, thus it’s okay to make concrete financial plans for them.

You should be saving for retirement. You should be saving for the future education of your child (assuming, of course, you believe you should play a role in helping to pay for it). You should be saving for your next vehicle, provided you have any sort of need to drive anywhere. You should have an emergency fund. Those things cover issues that you know are going to happen.

The same thing is true for other aspects of long-term planning. You know you’re going to get older and thus more susceptible to declining health, so it’s a very good idea to be proactive about your health starting right now so that you’re not stuck in a bad situation later on.

What about the other plans you might have for the future? If you’re not dead certain something will occur, plan for it in a flexible way.

For example, let’s say that you intend to move to a new house in five to 10 years, ideally one that you build in the country. There are several ways you can start preparing for this.

One way is to simply start saving for that goal. Start putting aside some money each month for a down payment on the land and the expense of building the house. That’s a good approach.

Another approach is to start shopping for land right now and, if you find a decent piece of land, take out a mortgage on it right away and start making mortgage payments. That’s a bad approach.

Why is the first one good and the second one bad? With the first approach, if your goal changes, you still have a big pool of cash in savings with which to use for your new plans. With the second approach, your money is tied up in a chunk of land with a mortgage on it and most of your mortgage payments have gone to just pay off the interest and you’ve been footing the property tax bill, too. Because you locked into a specific plan early, you’ve been pushing your money into a mortgage for years and property taxes for years and your only hope is that the value of the land has gone up a lot.

The thing to remember here is there are a lot of ways that this goal could go off the rails. You might have been intending it as a retirement home, only to get divorced or to have one of you pass away unexpectedly. You could simply decide together that you don’t want a house in the country any more. Maybe a job offer takes you away from realistically being able to live in the country.

The moral of the story? Stay as flexible as possible with your savings as you work toward a big goal that isn’t a guarantee. If you’ve got a big goal that’s five or 10 or 20 years down the road and it’s not something that’s guaranteed to happen, you should be saving for that goal in the most flexible way possible, so that those financial resources can be used for other things. This is why people often save for big goals in a normal taxable investment account that can be used for anything when the time comes. Other accounts, like a Roth IRA or a 529, are designed for tax advantages when used for specific purposes (retirement and college education, namely) but usually have a tax penalty if used for other purposes.

So, let’s summarize what’s going on with projection bias.

It’s a good idea to visualize your future because it helps you see things that are coming down the road and to set long term goals for yourself. However, those visualizations are often at least somewhat flawed thanks to projection bias. You can work around those flaws by only making specific plans and taking specific actions for things that you know are coming, like your own aging, and being much more general in your savings plans for all other goals that could change over time as your life situation and perspectives change.

No matter what, it’s a good idea to save for the future, because you’ll always have big things you want to achieve. It’s just a good idea to not lock down those future plans unless those big goals are inevitable.

Good luck.

Loading Disqus Comments ...