Behavioural Finance - Planning your holidays can open up new financial horizons!
March can be a good month for organising May’s long weekends – or even your summer holidays. Try basing your holiday plans on what you think you’ll want a few months from now: warmer temperatures? Hiking the great outdoors? Cultural activities? Lounging? These daydreams are actually a good time to focus on the tricky issue of projection and identify your “projection bias”.
Projection bias: when the warmer weather makes you want that house with a pool
Thinking about your future holidays can be fun – but it’s usually hard to anticipate what you’ll really be in the mood for come May or July. And besides, it’s easy to fall victim to “projection” bias, which is the belief that what we want right now is what we’ll still want in the (near or distant) future. The classic example is grocery shopping on an empty vs. a full stomach! How many times have you come home before lunch with far more supplies than you need? Many studies have been done on this, and the most comprehensive one(1) compares the amounts bid for a ham and cheese sandwich purchased before or after lunch and meant to be eaten either immediately or a week later. It won’t surprise you to learn that participants were ready to offer more (about +34% more) before lunch as opposed to after. But the real takeaway is how wide the gap grows (+61%) if that sandwich is supposed to be delivered and eaten a week later. Projection bias is reflected in how much someone overestimated their hunger and underestimated their fullness.
However, it might surprise you to know that this difficulty assessing our future needs can also affect the choices we make when we buy durable goods, which have a very long potential life cycle. A study(2) of the purchases of 40 million cars (4x4 or convertibles, black or white) and 4 million houses (with or without swimming pools, fireplaces, AC) analyses the impact of climate. According to the study, a temperature that’s 11°C (20°F) above the norm increases sales of convertibles by 8.5%, and a snowstorm drives 4x4 purchases up 6.5%. Even the car’s chosen colour depends on how hot and sunny it is. Homes with pools fetch higher prices if they’re sold in the summer. The list goes on...
All of this illustrates a type of irrationality that can affect our daily lives and how we manage our personal finances.
Want to make better choices? Be realistic!
Managing personal finances – allocating your assets, choosing your investments – requires you to focus on the present. Beyond the way things stand right now, you should consider the possibility of a future that you can’t control.
So it’s vital that you consider what will happen in the future in terms of:
Household income (don’t exaggerate), such as the impact of a job promotion on your income over time, the price you can sell your business for, your investment earnings (the impact of taxes or interest rates) and how much you make on the sale of your home.
Financial needs (don’t underestimate), including changes in your consumption habits, a jump in expenses due to inflation, the cost of your children’s education, and how long your retirement will last.
Projection bias often makes it harder to predict both, and this can result in inadequate planning for retirement (people don’t save enough because they have difficulty imagining how much their income will drop) or insurance (life’s accidents, by definition, don’t match the past).
Take the time to think about your current preferences, maybe in light of how those very preferences may have changed over the past few years.
We’ll leave you to organise your holiday now – much more fun!
(1) “Examining projection bias in experimental auctions: the role of hunger and immediate gratification”, T.Briz, A. Drichoutis et L. House, 2015
(2)“Projection bias in the car and housing markets”, M. Busse, D. Pope, J. Pope et J. Risso, 2012
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