Emergent Bias in Finance: Why You’re Underestimating Future Expenses

Think about how much you currently spend each month. Now think about if that number was doubled, tripled? Is it easy for you to imagine that life? If you are like me, you probably think that would be ludicrous. Outside of purchasing a mansion or a Rolls Royce, I can’t even fathom what my life would look like spending twice my monthly expenses. That’s the problem. Well that is the bias. Let’s call it… the “emergent bias”, our tendency to underestimate how our finances will change as our lives and businesses grow.

Many of us have heard of “lifestyle creep”, a very important phenomenon in personal finance. But we also need to think about our state of minds before we get there. Our personal and business finances take a similar journey. Different stages introduce different expenses throughout our life. At 13 your financial priority may have been clothes(my addiction was shoes), at 25 it may shift to rent, at 35 child care, and so on. We know this intuitively. If you are just starting a business your expenses are different than someone growing or scaling a business. Even though many of us know this intuitively, we are still surprised when we reach the next level of expenses, I know I was. Seeing a bill for $100 feels different than seeing one for $100,000 no matter how much money you make.

Another bias that comes to mind is the “end of history illusion” where we tend to think that change is behind us and underestimate the magnitude of future change. Popularized by Harvard Professor and Author Daniel Gilbert, this tendency is important to keep in mind because we underestimate the history of our finances just like our own personal history. Looking back, it’s obvious that we had to spend more to move, or to get a new car, or adopt a certain lifestyle. We can easily rationalize(or at least attempt to rationalize) these purchases, but it’s difficult to do the same thing looking forward.

Critically, business leaders should understand the inflection points in their own business where these expenses might be emerging. Identifying certain KPIs can help with this, for example have you reached a new benchmark in Revenue, headcount, locations, product lines? All of these metrics can help forecast and identify these critical times. Being aware of these emergent expenses won’t prevent them from occurring, but it will prepare you to face them with confidence and a plan to succeed.