Read Time: 4-minutes
Happy Saturday,
This week we’re covering one of the most costly mental biases in personal finance, and the 5 steps to get around it.
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Table of Contents*
*Clickable in the online version.
Point #1 — Your Money & Realistic Optimism
On September 9, 1965, U.S. Navy fighter pilot James Stockdale was flying an A-4 Skyhawk during a mission over North Vietnam when his plane was hit by enemy fire.
He was shot down near the city of Thanh Hóa and ejected from his aircraft, parachuting into a small village where he was immediately captured by the North Vietnamese.
Soon after, he was taken to Hỏa Lò Prison, the notoriously worst of the thirteen North Vietnamese prison camps. Hỏa Lò, which translates to “fiery furnace” or “Hell’s hole,” lived up to its name.
It was a brutal dungeon where captives were subjected to relentless physical and psychological torture.
Asked how he survived the seven years of unimaginable horrors, Stockdale said, “I never lost faith in the end of the story, I never doubted not only that I would get out, but also that I would prevail in the end and turn the experience into the defining event of my life, which, in retrospect, I would not trade.”
He was then asked, Who didn’t make it out of Vietnam? “Oh, that’s easy,” Stockdale said. “The optimists. Oh, they were the ones who said, ‘We’re going to be out by Christmas.’ And Christmas would come, and Christmas would go. Then they’d say, ‘We’re going to be out by Easter.’ And Easter would come, and Easter would go. And then Thanksgiving, and then it would be Christmas again. And they died of a broken heart.”
What you need after something bad happens to you, Stockdale said, is to blend optimism with realism.
“This is a very important lesson. You must never confuse faith that you will prevail in the end—which you can never afford to lose—with the discipline to confront the most brutal facts of your current reality, whatever they might be.”
I'm a firm believer that having an optimistic outlook is a huge advantage in life. I love how Stockdale said he would turn his unimaginable experience into the defining moment of his life.
But, left unchecked, optimism can lead to the exact outcomes we're trying to avoid.
So, blending optimism with realism is the key. Otherwise, you can quickly set yourself up for failure…
Behavioral scientists refer to an overly optimistic approach as optimism bias. It's the tendency to overestimate the likelihood of positive outcomes and underestimate the likelihood of negative ones.
In your finances, optimism bias starts with the stories you tell yourself:
"Once things slow down at work, I'll get serious about this."
"This month was just an exception. Next month I'll get back on track."
"I should be able to swing this purchase…"
And ends up wreaking havoc:
You underinvest in retirement for years
You put off building an emergency fund
You continue carrying high-interest debt
So, let's look at 5 ways to make sure an overly optimistic perspective doesn't quietly sabotage your future.
Point #2 — The 5 Steps to Beat “Optimism Bias”
1. Check Your Money Mindset
A question worth considering: When you think about saving money, are you thinking about right now, or are you mentally living in a future version of your life where things are a little easier?
Most people default to the second one. Things will improve. Income will grow. Life will slow down. That assumption is exactly where optimism bias does its damage.
Researchers [2013, Tam & Dholakia] tested two different mental approaches to saving. The first was a conventional, forward-looking method: set a goal, focus on the future, don't dwell on past mistakes.
The second asked people to focus on the present, treating saving as a recurring pattern rather than a future aspiration.
The results were striking:
People using the present-focused approach provided savings estimates that were 74% higher and actually saved 78% more money.
The difference comes down to what you use as your reference point. The conventional approach says the future is the destination: current behavior is just a starting point you'll improve on later.
The present-focused approach says your current behavior is your most honest signal of what's actually going to happen.
In other words, what you do today is probably what you'll do tomorrow.
Not because you lack ambition, but because optimism about the future can disincentivize you from taking action in the present.
2. Run a “Pre-Mortem” Test
Developed by psychologist Gary Klein and validated by Nobel Prize-winning economist Daniel Kahneman, a Pre-Mortem flips the traditional planning exercise. Instead of imagining what success looks like, you imagine the plan has already failed, then work backwards to figure out why.
For example, imagine it's December. You didn't hit your savings goals. Now ask: what happened?
This exercise forces clarity about the real risks optimism bias hides from you. The car repair. The unexpected trip. The “one-time” splurge that becomes a spending pattern.
3. Stress Test the Decision Before You Make It
Many people run one set of numbers on a big financial decision…the optimistic ones.
Take buying a car that would stretch your budget. Let’s assume your emergency fund is shakier than you'd like, but you think you might get a solid bonus and a decent raise. So, the payment seems doable...
Try building 3 scenarios before you sign any paperwork:
Best case: The bonus lands on time, the raise comes through, nothing unexpected breaks. The payment feels comfortable within a couple of months.
Expected case: The bonus is smaller than projected, the raise takes an extra six months, and an unexpected expense hits. You manage by cutting back your lifestyle spending but miss out on some experiences.
Worst case: The bonus doesn't come, the raise gets pushed, and a real emergency hits. The car payment that seemed manageable is now a big reason you can't cover an unexpected bill without going into debt.
That’s how you stress-test a big decision. If the worst case breaks your budget, the decision is riskier than optimism bias makes it seem.
4. Know Your Actual Risk Profile
Many people assume that the bad things in life usually only happen to other people: a disability, a lawsuit, or a pet emergency that runs $3,000 on a random weeknight. These feel like remote risks, when everything’s generally going fine.
But the data shows otherwise.
For example, did you know 1 in 4 of today's 20-year-olds will be out of work for at least a year due to a disability before they retire?
And 9 out of 10 people underestimate their own chances of becoming disabled.
That gap between perception and reality is optimism bias doing exactly what it does.
A few coverage areas where optimism bias can create dangerous blind spots:
Disability insurance
Term life insurance, if someone now depends on your income
An umbrella liability policy, if your assets have grown but your coverage hasn't kept up
5. Automate And Lock It In
Once you've completed the steps above, lock any decisions you can through automation.
Because automating good money behavior bypasses the chance for overly optimistic thinking to creep back in.
And it works. Richard Thaler and Shlomo Benartzi's “Save More Tomorrow” program, work that contributed to Thaler's 2017 Nobel Prize in Economics, found that participants who automated savings saw their saving rate rise from 3.5% to 13.6% over 40 months. Nearly a 4X increase, without the need for ongoing willpower or discipline.
Set the transfer shortly after payday. Start with whatever amount doesn't require heroics. The goal right now is the habit, not the amount. Then, increase it later.
One good decision today. Compounding forever.
Your Move:
Let’s return to the money mindset in step number one above. Look at what you saved last month. Assume you continue this amount for the next 5 years. Does that position you for where you need to be? If not, what’s one small action you can take this weekend to increase your savings?
Point #3 — “My biggest fear is getting priced out.”
“My fiancé and I are in our mid-20s and early in our careers. We both live with our parents right now (VHCOL area) because our jobs are near them. It works, but it sucks. It’s allowed us to save aggressively while still enjoying life a bit (vacations, nights out, etc.), but we’re definitely ready to move in together.
I’ve always wanted to be a homeowner and have never liked the idea of renting. Now that we’re engaged and our careers are starting to take off, we really want to make a move.
The challenge is that buying right now would be doable but tight. A starter home in our area (SoCal) would likely put our mortgage around 50% of our take-home pay, which is basically all of what we’re currently saving each month. We could make it work, but it would mean cutting back significantly on our lifestyle. The home would likely be small, probably need repairs, and probably extend our commute.
It would also make it harder to afford a wedding anytime soon since we’d want to keep our savings available for emergency home repairs.
The alternative is renting. We could rent a place for about half the cost of a mortgage, continue living comfortably, and have a wedding. We wouldn’t touch our down payment fund, but it would probably take about a year to rebuild the wedding/home emergency fund after moving out.
Another factor: my fiancé is expected to get a professional license in about 3 years, which should significantly increase her income and likely qualify us for a much better home. I would expect to get a significant promotion around that time as well.
My biggest fear with renting is missing our window and getting priced out if home prices spike again. I have family members who experienced that during 2020/2021.
Our priorities: Move in together soon, ideally have a wedding within the next couple years, eventually own a home.
For people who have been through something similar, how would you think about this decision? And how do you mentally get comfortable with paying rent when you could technically buy?”
This post caught my attention because it shows the tension between balancing optimism and realism in the extremely important decision-making process around homeownership.
These individuals are taking the time to consider what factors are important to them, the tradeoffs, and the risks. And there are a few things worth unpacking:
First, the math. A mortgage at 50% of take-home pay is far too much. The general rule of thumb is to keep housing costs at or below 28-30% of gross income. At 50% of take-home, there's almost no margin for the unexpected, and unexpected is just another word for normal.
Second, it's worth checking the actual returns on homeownership. It's often not the wealth-building machine most people believe it is. After accounting for the total cost of owning a home (maintenance, property taxes, insurance, and transaction costs) the long-run average annual return on home price appreciation in the U.S. has historically been around 4-5%, compared to roughly 10-12% for the stock market. The grass isn't always greener on the homeownership side.
Third, the fear of getting priced out is understandable. It's a universal fear. But it's worth reframing to something like: You can't miss a window you're not quite ready for yet.
None of this is easy to accept after years of living with parents and saving aggressively. That kind of discipline deserves a payoff, and renting can feel like squandering it…
But a few more years of financial runway means a healthy emergency fund, a funded wedding, and a mortgage payment that doesn't consume half their income. So they can actually enjoy two of life's biggest milestones.
Point #4 — “Impact Bias” Explained
While optimism bias distorts our expectations about outcomes, what’s called affective forecasting distorts our expectations about feelings. As you can probably imagine, the two can easily influence each other.
Psychologists Timothy Wilson and Daniel Gilbert coined the term in the 1990s to describe our tendency to predict how we’ll feel in the future, only to consistently get it wrong.
The specific error is called the impact bias. We overestimate both the intensity and the duration of the emotional payoff from future events. The promotion, the vacation, the home purchase—we tend to expect them to feel better, and for longer, than they actually do.
So when making big financial decisions, it’s worth examining any emotions you’re projecting onto an outcome. Because then you can ensure you’re not letting your feelings become an additional driver of optimism bias.
Point #5 — Quotes of the Week
Which of these quotes resonates most with you?
“Most of us view the world as more benign than it really is, our own attributes as more favorable than they truly are, and the goals we adopt as more achievable than they are likely to be.”
“While we are postponing, life speeds by.”
“I think that one should recognize reality even when one doesn’t like it; indeed, especially when one doesn’t like it.”
Point #6 — My Question of the Week
Are you more glass half-full or glass half-empty in your day-to-day life? And where do you think that shows up most in how you handle money?
Reply to let me know! I read every response.
Thanks for reading — I hope you found a helpful idea or two.
I’ll see you next Saturday with more.
Have a great weekend,
Benjamin Daniel, CFP®
Founder, Money Wisdom
P.S. Want to take control of your money, stop stressing about your expenses, & feel confident about your financial future? There are 2 ways I can help you:
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Disclaimer:
This material is not investment or tax advice. No responsibility for loss occasioned to any person or corporate body acting or refraining to act as a result of reading this material can be accepted by the publisher.
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