Optimism Bias

One of the realities that FP&A professionals need to realize is people tend to be too optimistic in their financial plans.  People tend to expect higher revenues, lower expenses, or less time to recover the amounts of their investments.  Psychologists label these expectations as optimism bias.

As an accountant, I am guided by the conservatism principle.  The conservatism principle frames financial reporting around errors.  The errors that I don’t want to make is overstating assets and net income.  Making these errors create an impression that I am presenting a situation that looks better than it is.  At its extreme presenting a situation that looks better than it is may be perceived as a fraud and this perception damages the most important qualification of an accountant, integrity.

When starting the process of preparing financial plans one needs to recognize the reality of optimism bias.

Events outside our control can hinder our best intentions.

The optimism bias is real in the financial planning process.  The reality is due to beliefs about the ability to maximize revenues, minimize expenses, and maximize net cash flows.  What is not believed, however, is events outside our control can hinder our best intentions.

When working with clients I emphasize that a financial plan is not perfect so I want the imperfection to lean toward the worse-case scenario.  This creates a perception that a financial plan is not trying to pull the wool over one’s eyes.  The good news is the financial planning process has two elements that improve our ability to minimize the optimism bias.

The two elements are Reference Class Forecasting and Pre-Mortems.

Reference Class Forecasting

An element that improves our ability to minimize the optimism bias in the financial planning process is Reference Class Forecasting.  Reference Class Forecasting is a process that uses similar situations and outcomes to forecast future events.  The purpose of Reference Class Forecasting is to take an outside view when preparing financial plans.

Reference Class Forecasting has three steps.

The first step is to identify an appropriate reference class.  Examples of reference classes are acquisitions of existing companies, development of new companies, and openings of new stores.  I organize financial plans around categories like these.

The second step is to obtain statistics of the reference class.  Examples of statistics are expenses as a percentage of sales, income as a percentage of sales, and length of time to recover investment amounts.  I obtain statistics in order to establish baseline forecasts.

The third step is to obtain information about the specific project.  The purpose of this step is to adjust the baseline forecast should specific reasons make this project different from other projects.  I like this step because it uses a bottom-up approach to justify decisions within the project under review.

Reference Class Forecasting is a process that I follow when preparing financial plans.  The process incorporates top down and bottom up thinking in order to prepare reasonable financial plans.  When this process is used the ability to minimize the optimism bias is achieved.

Pre-Mortem

An element that improves our ability to minimize the optimism bias in the financial planning process is a Pre-Mortem.  A Pre-Mortem is a decision-making technique.  The technique employs people who are knowledgeable about the decisions that affect a financial plan. 

The following is an example of a Pre-Mortem:

“Imagine we are one year into the financial plan.  The activities within the financial plan were implemented and the results were a disaster.  Write a brief history about the disaster.”

A Pre-Mortem provides two benefits.  The first benefit is it overcomes the groupthink that affects teams once a decision appears to have been made.  The second benefit is it stimulates imagination among knowledgeable people toward an appropriate direction.

I have two reasons for using Pre-Mortems.  The first reason is to expand the responsibility of preparing financial plans to people who directly affect revenues, expenses, and cash flows; even though I prepare financial plans I won’t perform the tasks that affect the elements within the plans.  The second reason is to honor the conservatism principle of accounting by having people think about events that won’t overstate assets and net income.

A Pre-Mortem is a technique that I use when preparing financial plans.  The technique incorporates people and processes in order to prepare reasonable financial plans.  When this technique is used the ability to minimize the optimism bias is achieved.

Systematic Thinking

Whether starting a new business, launching a new product, or expanding an existing business, people have expectations that may not become reality.  After all, we are human and our emotions can dominate our thinking.  As a result, our process to prepare financial plans may be influenced by optimism.

Financial plans have an important role in the activities within a business.  A startup needs a financial plan in order to raise money from prospective stockholders.  An established business needs financial plans in order to effectively use long-term debt and/or stockholders’ equity.  Raising money or using long-term debt/stockholders’ equity is not an unlimited source of financial capital; businesses have a limited amount of funds available.  The financial planning process, therefore, needs to include systematic thinking.

There are two ways to include systematic thinking within the financial planning process.  The first way is to use Reference Class Forecasting in order to establish baseline forecasts and think about how the actions of people can affect the baseline.  The second way is to use Pre-Mortems in order to consider unfavorable outcomes and think about the reasons for these outcomes.

Remember… one can think without planning but one cannot plan without thinking.