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Hyperbolic Discounting and You
Let’s imagine that I’ve decided to buy something from you. I’m completely trustworthy – if I say I’m going to do something, it will happen.
I give you a few choices as to how you’d like to get paid.
I can give you $20 for the item right now.
I can give you $40 for the item, but I won’t give you the cash until three months from now.
I can give you $80 for the item, but I won’t give you the cash until a year from now.
I can give you $140 for the item, but I won’t give you the cash until three years from now.
Which payment option will you choose?
Here’s the interesting part – according to Richard Thaler’s research article from 1981 in Economic Letters entitled “Some Empirical Evidence on Dynamic Inconsistency,” most subjects feel largely indifferent to these options. Most people are as happy pocketing $20 today as they are at the prospect of pocketing $140 three years from now. (I used Thaler’s numbers multiplied by a small factor to adjust for inflation and then rounded for easy understanding.)
This is called hyperbolic discounting, which means that people tend to discount the value of rewards in the future at a rate far greater than mere economics can account for. It’s particularly sharp over shorter periods, as in the example above.
If you compare these results to what you might get from a stock market investment, it’s easy to see why hyperbolic discounting is a really bad cognitive bias in terms of modern finances.
Let’s say I took that $20 and invested it in the stock market, which I can expect to return an average of 10% per year.
After three months, that $20 would grow to a whopping $20.48. Compare that to the $40 that was offered.
After a year, that $20 would grow to $22. Compare that to the $80 that was offered.
After three years, that $20 would grow to $26.62. Compare that to the $140 that was offered.
Now, 10% growth is a pretty nice low-effort investment return. You’ll be hard pressed to beat it consistently, year after year. Wise financial people would happily invest almost all of their money into things that returned 10% per year like clockwork.
Yet, the average person won’t just automatically take a 1,600% annual return because they won’t wait three months for the payoff. That’s the average annual return you’re getting if $20 turns into $40 in three months.
Is it really surprising that people aren’t lined up to invest everything they can to get a 10% average annual return?
Here’s another way of looking at the same issue.
Let’s say I offered to give you $20 today or $21 tomorrow, a delay in payment of a single day. Which would you take? Most would just grab that $20 today.
Now, let’s say I offered to give you $20 in 30 days or $21 in 31 days. We’re still talking about a delay in payment of a single day, but in that case, most people would take the $21 and wait an extra day.
(This phenomenon is very common and occurs at many different dollar amounts and time spans, as found in this study.)
Why do these things occur? The reason’s simple: We are extremely sensitive to the short term and much less sensitive to the long term.
Waiting a day right now seems like much more of an issue than waiting a day a month from now, so we will virtually always postpone that delay.
Having $20 in hand right now sounds just as good to most people as $40 in hand three months from now. Reduce that money in three months by just a little and most people would prefer the $20 in hand right away.
This is also a key element in why we tend to procrastinate. Doing a hard task now seems unpleasant and doing something fun now seems much more pleasant. However, the difference between doing an unpleasant hard task this weekend and a pleasant fun activity this weekend seems much less impactful. So, since the impact seems much bigger now, we choose to do the fun thing. Off to Netflix we go!
Most of us practice some hyperbolic discounting by default. We do it when we’re impatient or when we procrastinate or when we choose to spend frivolously rather than investing. Hyperbolic discounting is all about weighing your current desires over your future desires and needs, even if those future desires and needs may end up being far more important and valuable.
So, how do we overcome hyperbolic discounting? While I’m far from perfect at avoiding the hyperbolic discounting trap, here are some things I do to help nip it in the bud.
I try to put my current self in the shoes of my “future self.” If I put away $20 now, is my future self 20 years from now, probably in retirement, going to be happy that there’s approximately $100 more in that retirement account? Would the feeling of having another $100 exceed whatever fleeting joy I might get out of blowing that $20 today? I try to make that vision of my future self as real as I can, and the more effective I am at it, the more desirable saving for the future becomes.
I do the same with procrastination. I try to visualize as realistically as I can what I might do this weekend if I had a big block of free time. What would that be like? Then I compare that to the time-wasting thing I might do right now and, generally, the thing on the weekend appears much better. I use that as a motivation to do hard things now, which is why my weekdays sometimes seem like they’re packed to the gills with productive activity.
Establish big long-term goals, figure out a plan to get there, and think about the upside of that plan regularly. Where do you want to be in 10 years? Twenty years? Make that picture as clear in your mind’s eye as you can.
Now, what can you do today to take a step closer to that goal?
For me, this is a constant motivation to do something hard today so that I can be in a better place tomorrow. I envision myself as a healthy, wealthy, and wise person enjoying early retirement, working at a charity or working on a novel or exploring a national park and feeling good and happy with my wife and with my relationship with my children and having lots of good friends. What do I need to do today to make that amazing life happen? What do I need to do today to make sure that some aspects of it start happening now?
This eats into hyperbolic discounting because I’m focusing so intently on the big long-term goal. It inflates the value of that long-term goal in my head, and thus changes the terms of choosing between the short-term choice and the long-term choice today. I’m basically putting the finger on the “long-term” side of the scale to compensate for my own hyperbolic discounting.
When you’re feeling strongly motivated, make it easier to make good choices again in the near future. On a good day, I try really hard to ride that train of energy and motivation until the last drop. On a good writing day, I write and outline as much as possible so that on later days, I can devote full days to reading and brainstorming, which is a much healthier and efficient work cycle. On a high energy day, I do household tasks all day long, particularly ones that involve spending time and energy now to save money in the long run (like doing a meal prep day). This helps because then it becomes easier to make financially efficient choices down the road (with meals prepped in the freezer, I can just easily eat at home).
I try not to waste energetic days so that it’s okay for me to have lower energy days at other times and it’s also okay for me to have blocks of time later on to do more meaningful activities. I don’t feel guilty about spending a day doing hobby things on the weekend if I knocked it out of the park all week, so I try to knock it out of the park all week.
Automate, automate, automate. Whenever I’ve realized that something is clearly a good long-term choice, I try my best to automate that choice so that I actually have to take action to undo it.
For example, I automatically save for retirement each month, and my wife does the same. We save automatically for things like car purchases. We pay as many of our bills automatically as we can. I’ll do things like put a meal in the slow cooker in the morning so that supper is basically “automatic” that evening.
The reason that automation is so strong is that I only have to overcome hyperbolic discounting for a moment – the moment I set up that automation. After that, I have to actually put forth more effort to undo the automation than to just keep riding the wave.
In the end, hyperbolic discounting – our bias to way overvalue the present as compared to the future – is a known bias that almost all of us have. However, financial and personal success is often the result of overcoming and resisting hyperbolic discounting.
Know that it exists, watch for it, and kick it to the curb. You’ll be glad you did.
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