Five Reasons Your Financial Projections Are Wrong

Capital Budgeting

From time to time on our blog, we will take the opportunity to answer questions that have come up in prior client engagements for the benefit of our readers.

Why do our operating and capital budgeting forecasts always seem to turn out to be too optimistic?

Excessive optimism is a common problem in corporate forecasting exercises.  The good news – or maybe it’s the bad news, depending on your perspective – is that overly optimistic projections are not necessarily the result of intentional errors on the part of your family business managers.  Rather, behavioral economists tell us that humans are prone to overconfidence as a result of what they refer to as cognitive biases.  One of the best non-fiction books of the past decade explores how these cognitive biases function and their ubiquity in everyday life, including business forecasting.  All family business directors would benefit from reading Daniel Kahneman’s Thinking, Fast and Slow.  In this post, we present a thumbnail sketch of the most common cognitive biases contributing to overly optimistic forecasts.

1. Illusion of Control

We tend to ascribe far too much of the outcome (whether good or bad) to our interventions, and far too little to events outside our control.

Simply put, we humans fail to appreciate just how little control we have over the events that go on around us.  This tendency may well have some beneficial side effects in our everyday living, but it quickly becomes a liability when family business managers begin to forecast future results for a new project.  In looking back at prior events for guidance, we tend to ascribe far too much of the outcome (whether good or bad) to our interventions, and far too little to events outside our control.  As a result, we assume that – based on what we have learned from the past – we will do better this time.  However, our control over future outcomes – even if we have truly learned some valuable lessons, and will therefore execute better – is much smaller than we assume.  The result is a tendency to formulate overly optimistic forecasts, since we operate under the illusion that we exert far more control over the outcome than we actually do.

2. Availability Bias

The availability bias describes the fact that we tend to assign too much weight to observations that are easy to recall from our memory.  For example, someone contemplating a visit to the beach is likely to overestimate the likelihood of a shark attack relative to other perils because – although exceedingly rare – when sharks attack, it is news.

For family business managers, the availability bias manifests itself when scenarios that have either happened before or are easily imagined get assigned too much weight in a probability distribution.  We construct mental probability distributions not on the basis of statistical likelihood, but relative to the ease with which we can quickly generate examples of particular outcomes.  Successful family businesses have a history of good outcomes which managers unconsciously draw upon when assessing the likelihood of future outcomes.  This can contribute to overly optimistic forecasts.

3. Desirability Bias

The desirability bias names the tendency to accept things as true that we want to be true.  Since family business managers naturally want their proposed project to have a good outcome, the desirability bias suggests that they will actually screen out evidence or data that does not support the desired outcome (project success), while emphasizing and highlighting evidence and data that does support the desired outcome.  It is not hard to see how the desirability bias contributes to unrealistic projections.

4. Anchoring Effect

Behavioral economists use the term anchoring to describe the tendency for our estimates to get “stuck” on the first number we see or impression we receive, even when there is no logical basis for doing so.  Kahneman provides the following example of the anchoring effect: when asked to estimate Ghandi’s age at death, individuals who are initially asked if he was older or younger than 114 will estimate a much older age than individuals preliminarily asked if he was older or younger than 35.  The preliminary question has no bearing on the estimate of Ghandi’s age, but respondents invariably get anchored to that initial number.

Since the initial expectation for any capital project is that it will be successful (otherwise it wouldn’t be seriously considered), it is natural for family business managers to become anchored to the initial expectations, even in the face of evidence to the contrary.

5. Extrapolation Bias

We fall prey to the extrapolation bias when we assign too much weight to recent events.  A classic example is that after seeing a coin-flip land on heads five times in a row, people will begin to extrapolate that trend into their expectations for future outcomes of the coin-flip even though the results of previous coin flips have no effect on the outcome of the next flip.

For family business managers, the extrapolation bias comes into play when the 15% revenue growth experienced last year is assumed to persist even in the face of no, or contradictory, evidence.

Organizations, like family businesses, are better equipped to counteract the baleful effects of cognitive biases than individuals are.

Apologies if this list seems a bit depressing.  If these biases are really a part of human nature, must family business directors be resigned to receiving overly optimistic project forecasts?  The good news, as summarized by Kahneman in Thinking Fast, Thinking Slow, is that organizations like family businesses are better equipped to counteract the baleful effects of cognitive biases than individuals are.  The two most important steps that family businesses can take are to (1) promote awareness among managers of what the cognitive biases are and how they influence forecasting, and (2) create and institute procedures that help limit the damage from cognitive biases.  Our family business advisory professionals can help with both tasks; give us a call to discuss your needs today.