Forecasting the future is hard. Really hard. I would even venture to say impossible in some respects.
What’s bizarre is that people have a hard time forecasting the future about themselves. By that I mean we aren’t very good at predicting our future states of mind. While we might get the broad outlines right, we still tend to get tripped up when imagining how we’ll react to future events: Strong feelings fade. Positive events tend to make us less happy than we expect, negative ones don’t make us as sad.
The problem is that we often have to make decisions today that hinge on our ability to correctly forecast our future feelings. But if the forecast motivating the decision is no good, then it’s probably not a good decision.
Why does this happen? Blame the psychological quirk known as affective forecasting. Here we’ll look at how it works and consider some ways to help bring it under control in order to help with financial planning.
Unpredictably predictable
Emotional reactions follow a predictable path, with an acceleration up, a peak and then a tapering off as the emotion fades. It turns out that we’re not very good at predicting any of these steps. We overestimate the acceleration, imagine the peak will be higher and then underestimate how quickly we’ll move on.
This misunderstanding is rooted in a failure to appreciate how easily we adapt to changes thanks to what scientists call our “psychological immune system.” When asked to make a prediction about how we’ll react to some hypothetical event, we tend to fixate on just one imagined emotion—I’ll be devastated if my team doesn’t win tonight!—without taking into account how hard our minds will work to rationalize it after the fact or that all the other aspects of our lives will still be there competing for our attention and thus distracting us from the pain.
This inability to imagine our future state of mind can cause us to misjudge how our preferences might change over time—which can be a major stumbling block for retirement planning.
One study showed how a rising standard of living can cause our tastes to change, leading to both excessive spending and inadequate saving. The idea is that spending money is habit-forming—and gets more expensive over time as it creates self-reinforcing cycle of constant upgrades. The thrill of owning a nice TV fades and new models beckon. This creates a mismatch between our tastes and our resources, until we arrive in retirement with expectations of a high standard of living but insufficient funds to pay for it.
Defenses up
Use these tips to help guard against affective forecasting errors when it comes to your financial plan:
When making financial plans, account for the fact that your future tastes and expectations could be much different than they are today. Creating a financial plan starts with a declaration of goals for the future. But how can you set a useful goal for yourself when you don’t know who you’ll be in the future? So be flexible and make sure your financial plans have room to course-correct as time goes by. That means you shouldn’t just draw up a plan and stick it in a drawer. Check on it at least annually and make changes to accommodate the changes in your life, your feelings and your preferences.
Be careful when extrapolating future experience from past experiences. When we think about retirement planning we naturally think about spending plans. None of us have infinite savings so we need to make choices about what we consider priorities and what should be relegated to the “nice to have” category or the “not gonna happen” category. But there’s a challenge here: A common technique for making these tradeoffs is to think about our past experiences and then use them as the basis for forecasting our future preferences. But what if our memories of those experiences is flawed? Memory can be surprisingly inaccurate. If a honeymoon trip you took 20 years ago makes you think you’ll want to spend 20% of your time in retirement traveling the world, then I would suggest you do some deeper thinking. Was the trip really that great? Is it safe to base such a big decision on a memory that may be distorted by rose-colored glasses?
Don’t freak out if your retirement planning looks like it might come up short. If you’ve ever looked at an online retirement calculator and been disappointed with the results, think carefully before making any major changes to your retirement plans. Just because a website might recommend you double your savings rate or work 10 years longer than you planned if you want to hit your target numbers, that doesn’t mean you should automatically do so. While I wouldn’t discourage you from considering such measures, I would also suggest a more practical approach could be to recalibrate your retirement goal. Maybe you can make do with less than you originally forecast. So review the list of things you’d like to spend your savings on in retirement. For each ask how important it will be to your happiness in your golden years. What may seem like vital spending now, may not be all that important to you then. Think about alternate methods that fulfill the same needs, but cost less.