“It’s very hard for the human mind to conjure up contingencies and to think of everything that could happen in the future."
Published January 19, 20223 min read
An important part of financial planning is predicting future expenses. It turns out we’re really bad at this.
Research published in December in the Journal of Marketing Research shows evidence that people have a tendency to “significantly under-predict their future expenses.”
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While you might have an easy time remembering to pay your rent or car loan, people often forget atypical expenses, like medical bills, car repairs, or your kid’s field trip, says Chuck Howard, assistant professor of marketing at Texas A&M’s Mays Business School and one of the authors of the paper.
“It’s very hard for the human mind to conjure up contingencies and to think of everything that could happen in the future,” Howard says.
The authors of the paper — Howard, as well as professors David Hardisty of the University of British Columbia, Abigail Sussman of the University of Chicago, and Marcel Lukas of the University of St. Andrews — call this “expense prediction bias.” The evidence for this bias comes from a series of studies dating back to 2016 that involved more than 6,000 participants altogether. Researchers asked them in various ways to predict their future expenses.
What the researchers found was that people repeatedly underestimate their expenses. This could obviously have a cascading effect on your money.
“If you under-predict every week, by the end of the month, you could be in hot water,” Howard says.
Luckily, the researchers also discovered a simple way to nudge people into making more accurate predictions. Before asking them to make their predictions, they asked them to think of reasons why their spending might be different that week or month. When people did that, their predictions tended to be more accurate.
Budgeting can also help, says Alvin Carlos, a certified financial planner and managing partner for District Capital Management. Carlos was not involved with the study, but says people he advises often underestimate how much they spend on dining, shopping, and entertainment, as well as unexpected expenses.
He recommends having a separate line item for “miscellaneous” expenses in your budget for unexpected costs. You could go as far as creating a separate savings account for it.
The existence of this bias is also a good argument for an emergency fund covering at least six months worth of expenses (or more).
“If you have to all of a sudden fly out to the West Coast for family reasons, you can just dip into that fund, and work afterwards to replenish it,” Carlos says.
Howard and his colleagues are working on a study of how budgeting impacts expense prediction bias. What they’ve found so far is that setting a budget and tracking your spending against it can lower your spending, even if you don’t get under your budget.
For example, if you normally spend $500 a week and set a budget of $400, you might not meet your goal of spending $100 less, but you’ll probably lower your spending to some degree. This might be demotivating, but Howard says it helps to keep your past spending in mind.
“The important thing to remember is you used to spend $500,” Howard says. “If you can bring that to mind, you’ll keep motivated to hit your goal of $400 eventually.”
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