How good are you at estimating?

Strategic decision-making often requires you to estimate current and future quantities. Here’s a quiz to see how good you are at it.

For each quantity below (2009 data unless noted otherwise), make your best guess. Don’t try to find the answers, just guess.

  1. World camel population
  2. Annual consumption of popped popcorn in the US (quarts)
  3. GNP of Belgium ($M)
  4. Number of cats in the US
  5. Population of Romania, 2007
  6. Amount of dog feces produced each day in the UK (tons)
  7. 2007 US corn production (thousand bushels)
  8. Value of all the tea in China (annual production) ($)
  9. Total amount of gold ever refined (kg)
  10. Acres planted in cotton in the US, 2006 (thousands)

Now how confident are you in your answer? Give a high and a low guess so that you are 90% certain that the true answer lies between high and low.

Don’t check the answers below until you’ve done this!

Businessman with Question

 

 

 

 

 

 

 

alternatives

 

 

 

 

 

 

 

 

 

 

Here are the answers. Give yourself a point for any question where the answer was between your high and low.

1          World camel population         18,871,000

2          Annual consumption of popped popcorn in the US (quarts)            16 billion

3          GNP of Belgium ($M)            $264,000

4          Number of cats in the US       76,430,000

5          Population of Romania, 2007 22,276,056

6          Amount of dog feces produced each day in the UK (tons)    992

7          2007 US corn production (thousand bushels)            13,073,893

8          Value of all the tea in China (annual production) ($)  $1,590,653,400

9          Total amount of gold ever refined (kg)           154,400,000

10        Acres planted in cotton in the US, 2006 (thousands)            15,274

 

How did you do? If you really were 90% certain, you’d expect to get a score of about 9.

I’ve never had anybody get that much. Most people will score maybe 1 or 2. Why is that? It’s the overconfidence bias. We tend to think we know more than we really do. We tend to lock into an answer and then have trouble thinking much beyond it. This is a natural human bias that stifles our imaginations and leaves us unprepared for inevitable changes.

You probably didn’t know the answers to any of these questions. Admit it! Give yourself a wide latitude for the possibilities. Have you ever been caught by the overconfidence bias, or seen others get caught up in it?

Are small schools better?

small schoolCan you get fooled by random events? You bet you can. Here’s an interesting example, recounted by Daniel Kahneman in his book Thinking Fast and Slow.

A survey of average student test scores at over 1600 schools focused in on the top 50. One item stood out. Of the 50 best schools, 6 were small. This was surprising since there were very few small schools in the study. In fact, the small schools were overrepresented among the best by a factor of 4. This started the small school movement, supported by the major foundations and the US Department of Education.

Yet, if you looked at the bottom 50 among the same schools, you would see small schools overrepresented there as well. If the study had focused on fixing bad schools rather than emulating good schools, they might have seen this data and concluded that bigger is better. What’s going on here?

There’s a simple explanation that shows that this anomaly is not only possible, but to be expected. It’s all explained by the Central Limit Theorem, which says that the more items you average, the smaller the variation from one average to the next. If you look at the test scores of individual students, you will see the full range, including both some very poor and very good students. These individual differences swamp any educational differences. You won’t see this spread in the average test scores for a school, since there will usually be a mix of very good and very poor students, who average each other out. In fact, a very large school will closely match the general population, and so will have average test scores very close to those of the general population. In other words, the big schools will all have about the same average test scores. On the other hand, a small school may by chance have a few very good or very poor students who swing the average, so the average scores at the small schools will show more variability than those at the large schools.

Now when we look at the very tails of the distributions, we find small schools, not because they’re better or worse, but simply because their average scores are more variable. So which is better? We really won’t know until someone does an analysis that includes all the schools.

Simple spreadsheets for complex questions

magic bar graphIsn’t it hard to build a spreadsheet to analyze financial issues? Don’t you need to be a math whiz? Don’t you need to write complicated formulas into all those cells? No, no, and no!

You can do a lot with just addition, subtraction, and multiplication, and Excel will do all the arithmetic for you. The formulas are actually quite simple, and Excel will write them for you. One good formula and you can fill an entire column, or even the whole spreadsheet.

As an example, some recent posts included spreadsheets for thinking about some complex financial questions including:

  • How much money do I need for retirement?
  • Am I saving enough for retirement (or any other goal)?
  • How much faster will I pay off my mortgage if I add $100 a month?

Even though these are complex questions, there are only a few formulas in each of these—the rest of the cells are just copies. The formulas use no more than addition, subtraction, and multiplication. Best of all, you just tell Excel what you want it to do and it writes the formulas for you.

Take a look at the spreadsheet for retirement spending.

formula

There are formulas in the Spending column to predict your spending each year as it rises with inflation. Take a look at one of them: =B8 + B8*Inflation. This is where people get scared off. Come back! Excel formulas are much easier to write than they are to read. You get Excel to write this just by thinking through what you want it to do. First type “=” to tell Excel to write a formula. Then think about how much you’ll spend that second year when you add in inflation, “I’ll spend the same $50,000 I spent last year, plus the inflation amount, which is 4% of the $50,000 I spent last year.” When you think “$50,000 I spent last year,” click on the $50,000 under spending. When you think “plus” type +. Follow this with the inflation amount, 4% (click on it in the inputs) of the (type * for multiplication, since you take percentages by multiplying) $50,000 I spent last year (click on it under Spending). When you enter it, you should get the answer. The same thinking will get you the funds growth, and then you just need to ask Excel to subtract the spending amount in the same row.

Here’s where the magic happens. AutoFill these two formulas down the column to complete the spreadsheet in seconds. That’s all there is to it. All of these spreadsheets are built this same way. Just be sure to name your inputs. To learn more about these Excel techniques, see my posts from September to November, 2012.

Do you have any financial issues you’d like considered? Let me know and I’ll feature them in future posts.

How much money do I need to retire?

Planning budgetAre you saving enough to retire? That depends on how much you need to have when you enter retirement. Last time I showed you a spreadsheet to help one of my clients amass $2,000,000 by the time he retires. But will that be enough? We can build a simple spreadsheet that gives you a start on answering this. Let’s start by figuring that he’ll need about $50,000 a year. The rule of thumb is you’ll need 70% of what you earned while working, but I’ve talked to many retirees who say that’s not nearly enough. It depends on your retirement plans. Will you downsize or will you spend your new-found time in travel or other costly pursuits? The idea of this spreadsheet is to help you visualize the relationship between how much you spend and how long the money lasts.

He’ll want to invest cautiously to avoid losing his nice nest egg. (More about that in a later post.) Let’s say he averages 4% growth a year. He’ll also find that his spending will go up each year due to inflation. Figure 3% for that. Let’s say he retires at age 65. Of course, you can change any of these assumptions and see what happens.

Here’s the spreadsheet, retirement spending

retirement spending xlsAs you can see, this is a good spending plan. He’s not expected to run out of money until he’s 115.

Maybe he can spend more. If he spends $100,000 per year (try it), he’ll run out at age 87. It helps to play what-if with this until you get something that feels comfortable. A common rule-of-thumb is to spend 4% of your nest egg the first year. In this case, that will be $80,000 a year and it will cover him to age 92.

You’re your own financial advisor, even if you’re working with someone else. Only you can decide where you want to be in the future and how much risk you’re willing to take. A spreadsheet like this doesn’t give you a single answer; it helps you visualize your options. It often raises more questions than it answers, and leads you to the key issues. Will I need to work longer? How long might I live? Do I need to increase my retirement savings?

What is…? or What if…?

???????Which would you rather know, where you are now compared to where you were last month, or where you might be in the future? Personally, I’ll take the view of the future. What might change and how can I prepare? Are there threats? Opportunities? What might I do to make progress and how well might it work?

Yet much business analysis focuses on month-to-month status. This is especially true of the ubiquitous dashboards that seem to be the major product of Microsoft Excel these days—a beautiful, but static, view of the moment.

Forget the dashboard that compares where you are to where you were. In the current environment, you need analysis to tell you where you should be going. Use the dynamic and interactive powers of Microsoft Excel to visualize the future, compare your options, set requirements to lead you to your goals, find what will drive success, understand your risks, and more. Ask “what if,” not “what is.”

A couple of posts back I gave a spreadsheet to figure out whether you should marry a millionaire. Even if you don’t have such an opportunity (few of us do), you could use the exact same spreadsheet to figure out how much you can afford to spend in retirement, or how much you need to save to support a comfortable retirement. It looks into the future and compares your expected savings with your expected expenditures, year-by-year. It’s not beautiful, but it gives you answers. You can ask “what if” about things you can’t control. What if inflation goes nuts? What if my investments stagnate? You can ask “what if” about things you can control. What if I start with more money? What if I spend less? Change the assumption, see the result. No pretty graphs, no fancy graphics, just instant insights.

Choices for Change

Woman Riding Bicycle in BerlinYou always have more than two choices in any decision. A lot of decisions come out of a problem or dissatisfaction. The temptation is to jump in and do something right now, especially if you’re angry. Before you do that, settle down and make a list of possible alternatives that will remove, mitigate, or otherwise deal with the problem. Remember that the idea is to generate as many alternatives as you can. Some will be clearly ludicrous or even unsavory. Don’t worry about that now. You’ll get to throw those out later. Right now, open your mind to the full range of possibilities.

Here are some general possible alternatives.

  • Hope for someone else to change (Good luck with that!)
  • Help someone else to change
  • Remove the problem
  • Remove the source
  • Remove yourself
  • Change the problem
  • Change the way you deal with it
  • Accept it

— Hope for someone else to change

This is usually the first alternative people think of when they’re dissatisfied. “The problem is my boss.” If not your boss, it could be your spouse, your coworker, or some seemingly incompetent service worker. Even though this is the most obvious solution, it’s generally the least likely to succeed. Often people get stuck taking this as the only solution. Then the only action they can take is becoming increasingly annoyed with the other person. The result of your decision process must always be what you are going to do.

Here’s an example. My coworker Bob rides his bike to work and keeps it in the hallway outside his cubicle, making it hard for me to get to my own cubicle. One alternative would be silent resentment toward Bob for causing me inconvenience.

Help someone else to change

Come up with alternatives on how you can get the other person to change their behavior. This could be simply talking to them. Better yet, think of alternatives that you can undertake to remove barriers that they face. Remember that people are not going to change just because you want them to. You may need to offer to do something for the person in exchange. Here are some other alternatives for our example.

  • —  Ask Bob to keep his bike out of the hallway.
  • —  Help Bob find a better place to keep his bike.

—Remove the problem

Focus first on the problem, not the people. Once the problem is well framed, think about how it could be removed. Ideally the problem can be solved to the satisfaction or all.

In our example, the problem is the bike in the hallway. Here are some possible alternatives (clearly, some better than others, but right now we want a rich list).

  • —  Throw the bike out the window.
  • —  Get management to institute a rule against storing bikes in the building.
  • —  Put the bike in Bob’s cubicle.
  • —  Find someplace else to store the bike.

—Remove the source

Think about what is causing the problem, then how it could be mitigated. Do a causal analysis. That is just a fancy way of suggesting that you look for the causes of the causes. In our example, Bob has caused the bike to be in the hallway, so he is the source of the problem. But if we dig deeper, we find that Bob stores the bike in the hallway because there is no other safe place to keep it. Also, the problem arises simply because Bob rides a bike to work. Perhaps he has no car or he wants the exercise. Here are some more alternatives:

  • —  Get Bob fired.
  • —  Have the company install secure bike storage.
  • —  Buy Bob a car.
  • —  Buy Bob a gym membership.

—Remove yourself

It’s sometimes more effective to avoid the problem than to fix it. Leave a bad relationship. Check out early from a dirty hotel. Quit a dead-end job. Avoid a business that gives your poor service. Often this is hard to do, especially if you’ve put a lot of yourself into trying to fix the problem. We don’t like to be quitters. That’s why it’s especially important to add this option to your list of alternatives. Empower yourself to walk away if it makes sense. Here are some more alternatives for our example:

  • —  Quit your job.
  • —  Work exclusively from home.
  • —  Ask to be moved to a cubicle in a different location.

— Change the problem

Try to think of ways that the problem can be less of a hindrance. Suppose you can’t solve or remove the problem and you’re unwilling to leave. Can the problem somehow be contained or reined in?

In our example, if we accept that Bob will always be leaving his bike in the hallway, is there anything we can do to make it less of a hindrance to those walking by? Here’s a possibility:

  • — Find a way to mount the bike to the side of the cubicle or otherwise get it out of the flow of traffic.

— Change the way you deal with it

Again, suppose you won’t be able to remove yourself or the problem. Can you change your own behavior to keep it from bothering you so much?

Accept that Bob will always leave his bike in the hallway next to your office. Is there a way that you could avoid it or make it easier for you to get by it?

  • —  Find a way to approach your cubicle from the other direction, avoiding the bike.

— Accept it

This should always be on your list of alternatives. It’s remarkably liberating. Accept that people won’t change their behavior and the problem will persist in its current form. Choose to live with it.

—Accept the fact that Bob will always leave his bike in the hallway and you will need to squeeze past it to get to your cubicle.

Two of these alternatives, the first and last, are superficially the same. You can wait for someone to change or you can accept the situation. In either case you do nothing at all about the problem. But there is a world of difference in how it makes you feel and how effective a decision-maker you can be. In one case, you waste a lot of energy on something that may not change, resenting the person causing the problem and building stress. On the other, you have the peace of knowing that you made a conscious choice for acceptance and can focus your energies elsewhere. On one hand, you are at the mercy of someone else’s choices. On the other, you have taken charge by making your choice after considering all of your other options.

When you put together your list of alternatives, you’ll be tempted to drop some of them immediately. Many of the alternatives in the example are intentionally ludicrous. Buying Bob a car or destroying the bike is clearly overkill. For now, resist this temptation to throw out options. You want to keep yourself in a mode of divergent thinking. Evaluating the options is convergent thinking, which inhibits the open-mindedness you need right now. A good list will include one or two preposterous ideas. You’ll get to evaluate your options later.

Some of these options appear ridiculous when looked at dispassionately in an exercise. For example, it would be stupid to wait passively for Bob to move his bike and build up a level of resentment and anger to the point that you throw the bike out the window. Yet people do things like this all the time. You can probably think of several examples in which a petty problem led to rage and destructive behavior far out of proportion to the original annoyance. Take charge of your decisions before the rage builds.

It’s gone, you can’t get it back, and it’s making you crazy

Iempty wallet - woman with no money shopping just read a great article about thinking mistakes and how they mess up our decision-making. This article covers eight mistakes, any of which could be the basis for an article by itself. It also includes some terrific cartoons illustrating confirmation bias.

Right now I want to focus on mistake #3, the sunk cost fallacy. This is the natural human tendency to focus on what we have over what we could gain. We especially focus on the costs of whatever it is we have. I have a suit in my closet that I bought several years ago at great expense. I had been looking for a long time for such a suit. I had it altered so it fit perfectly. Well, that was then, and it no longer fits. It’s out of style. If someone offered to give me a similar suit, I wouldn’t take it. Why should I take a suit that doesn’t fit? So why do I have this suit still hanging in my closet? It’s because of that focus on the “sunk cost,” all the time and money I put into the thing. That money is gone and I can’t get it back, whether I wear it, keep it in my closet, or get rid of it. It’s gone. Get over it.

Many experiments have shown how strong this irrational bias is. In one cited in the article, people chose a less desirable option simply because they had sunk more money into it. Daniel Kahneman, quoted in the article, attributes this to the self-preservation instinct that kept our ancient ancestors alive.

But we’ve moved beyond that. To make the best decision, ignore the sunk costs. Maybe you put a lot of effort into the relationship, but it’s not working. Maybe the item was expensive, but you don’t need it anymore. Maybe it took you a long time to get here, but it’s not where you want to be. Yes, it’s hard, but all that is gone. Get over it. Here’s the big question. What’s the best option looking forward from where I am right now?

Yes, that suit goes.