Optimism Bias Can Raise Financial Risk in Divorce

Prenups aren’t for everyone, says this author, but all couples should carefully weigh why they might need one.

By Peter Neuwirth

Author’s note: In my final essay in this series, I examine optimism bias, and specifically it’s impact on my decisions around my own marriage and impending divorce. It is an important principle that I wish I included in my book “Money Mountaineering.” This is my attempt to rectify that omission while expanding on the notion that financial wellness requires that we acknowledge our cognitive and emotional limitations.

Principle #6: Optimism Bias

In “Money Mountaineering,” I describe eight emotional biases and seven systematic cognitive errors that we are all prone to. However, I left out one emotional bias that not only is important but that I recently fell prey to in my own life. Ironically enough it was probably this bias itself that caused me not to explicitly address it anywhere in the book, and it is one that I want to talk about now. Specifically, I am referring to what is called “optimism bias.”

Optimism bias causes someone to believe that they are less likely to experience a negative event than what the probabilities actually are. While this bias has been observed by psychologists since the 1980s, systematic analysis of this bias only began in the last 20 years. Here’s an example.

I doubt that adding one more bias to my Chapter 11 catalog of our emotional biases and cognitive errors would have made for better reading, but still, I regret not discussing it – especially because the financial consequences of optimism bias can be significant.

Right now, I am suffering the consequences of what can happen if you ignore the full range of unpleasant ways a decision might turn out. Fundamentally, I experienced a failure of imagination and I want to talk now about how it happened.

Time traveling and imagining a painful future

In the last chapter of my first book “What’s Your Future Worth?” I describe the first conversation I had with my wife about our respective personal balance sheets. It happened on our very first date as we were getting to know each other; both of us very much realized that we liked each other very much. We disclosed our financial situations to each other — my significant accumulated assets and her bright red ledger full of student debt accumulated in pursuit of her PhD.

That initial conversation took place in 1995, and the next time we addressed the subject was shortly before we got married at the end of 1998. In that second conversation, my bride-to-be asked me whether I was going to ask her to sign a pre-nuptial agreement to deal with the wildly different financial situations we were bringing to the marriage.

In one sense, this question was not about money. In another sense, it was only about money. In fact, it was a very specific question about what would happen to our money during the marriage, and more importantly – what would happen to our money if our marriage did not survive.

It was not as if I hadn’t thought about the question. I had. In fact, I had thought very deeply about it and when my fiancé asked the question, I was not the least bit surprised.

Before I tell you how I answered her, I need to first acknowledge that my wife and I separated at the end of March 2020. It was shortly after Covid locked us down together in our house in Berkeley. I moved out to live full-time at our farm in Santa Rosa, and that is where I live now. We are currently in the process of working through the excruciating details of a legal divorce that I hope will end soon.

Divorce stats are grimmer than they look

Divorce is a financially significant life contingency that affects many hundreds of thousands of married couples every year. And that is in normal years when there are no wars or pandemics – events that seem to bring some families closer and blow others apart.

For example, right after World War II the divorce rate in the U.S. was higher than it was in 1955, the year my parents got married (3.7 per 1,000 people in 1947 versus 2.3 per 1,000 in 1955). My parents recently celebrated their 66th wedding anniversary. I won’t, although the annual divorce rate throughout most of my marriage has “only” been between 3.5 and 4 per 1,000.

Part of the issue is just pure math. Note that over a 20-year marriage even a 3.5% annual divorce rate means that you will have less than a 50-50 chance of emerging from two decades still together. I was well aware of that fact when I got married, but I did not let that dissuade me. For me, the risk was far, far outweighed by other non-financial considerations, and if you read What’s Your Future Worth? you will understand why.

Optimism bias and other problems

I think there are two main reasons that I am in my current situation. The first and obvious reason is that I simply fell prey to optimism bias. The fact is, I just didn’t believe it would happen to us. It’s not like I shouldn’t have known better. As I said, the data told a pretty clear story. But the problem with average data is that we all like to believe we are not average. In fact, we aren’t — but averages do matter, and our emotional biases very often steer us to ignore the odds that we can use to make better decisions.

Actuaries are people too, and I was not immune to the perils I outline in Chapter 11 of “Money Mountaineering.” I was convinced I knew better. Although I periodically visited actuarial websites where an algorithm would calculate my actual individualized odds (always telling me I was a heavy favorite to get divorced), I simply would find reasons for their being wrong. Finally admitting defeat was not easy. Especially when my optimism bias made it so much harder to realize that my marriage was finally over.

Had I realized what was happening at the time, I might have written about it. But had I done so, I wouldn’t have written it in the way I would now. I now understand the nature of the financial risk divorce poses much better and it is very complicated, particularly with respect to the timelines and unexpected financial surprises (mostly bad) that inevitably arise when two human beings decide to end their marriage. We are not rational creatures, and I guess that is why we have lawyers to help us sort things out.

‘What if?’

That being said, there was a time when I was thinking pretty rationally, and that was before the marriage. When my fiancé and I sat down to discuss the prenup, I had considered as many scenarios as I could imagine, but almost all of them involved enduring some very painful time traveling. Although I did my due diligence and took steps to prepare for the contingency, it was not an exercise I enjoyed or did particularly well.

Every individual’s probability of getting divorced is a function of many variables, some known (such as age and duration of marriage) and others unknown and often random. Many random events come from an unknown distribution that we can never discern.

One thing I did do and you can do, too, — when addressing divorce and all the other life contingencies that you don’t want to think about — is to ask yourself a lot of “what if” questions and then try to inhabit your future self. When you get there, look at the possible financial situation you will find yourself in, and try to imagine how you will feel under each one. It’s painful work, but it can help you make better financial decisions.

No regrets, but a big lesson

These days, when I am often tempted to kick myself for making a boneheaded decision, I remember [professional poker player] Annie Duke’s counsel against “resulting.” Resulting is thinking you made a mistake just because your decision turned out badly. I still feel like I did the right thing; it just didn’t turn out as I had hoped.

For obvious reasons — legal and ethical — I won’t disclose any more of the details of my divorce. I will, however, tell you the rest of the conversation my wife and I had before we got married. (At least, I will tell you my memory of my side of the conversation.) I do so because one of the first decisions you might have to make before you get married and before you must decide whether to say “I do” to whomever is empowered to witness your contract, is to decide whether or not to have a prenup.

I said no to the prenup. I said I thought that California divorce law was perfectly reasonable: Whatever assets each party brings to the marriage is separate property and only the assets that we would acquire as a couple would be split 50-50. For me that was fair, and I didn’t see any need to make it any more complicated than that.

I still believe it was a reasonable decision and I would make the same decision today if I was faced with that choice. However, I now know, and I want you to know, that I materially underestimated how complicated (and painful) ending a long-term marriage like ours could be.

Still optimistic

Even though I have not been immunized against optimism bias, I am fundamentally an optimistic person even though I act with more than a little caution about the extreme risks, both financial and otherwise, that lurk in the wilderness in which we live. I try not to advise anyone on what I think they should do but instead will tell you what I do and why. In the end, you are the expert on your own financial decisions and the only one who can ultimately make them.

I hope you choose to read about my ideas, and you find them helpful.

Happy trails, Pete

Peter Neuwirth, FSA, FCA, is a fellow of the Society of Actuaries and the Conference of Consulting Actuaries and a consultant for large corporations on their retirement plans. This excerpt is from his essay about principle 6 of holistic planning.

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