Your Mind and Your Money: Hyperbolic Discounting

Welcome once again to our continuing discussion of how your insane brain is costing you money.  You might think I’m exaggerating, but as we’ve seen already this week, there are a number of ways you brain doesn’t think entirely logically about money and investing.  One way that is particularly harmful to your investing and saving motivation is:

Hyperbolic Discounting

In its simplest form, hyperbolic discounting is an overemphasis of the old adage, ‘A bird in hand is worth two in the bush’.  When given the opportunity to have a relatively small amount now or delay our gratification for period of time and get a much higher amount of money, many people choose to take the smaller amount immediately.  The most commonly cited research (Green et al. 1994) shows that if people are given the choice between $50 today or $100 a year from now, most people will choose the $50 dollars today, in spite of the fact that the $100 will almost certainly still be worth more a year from now.

Interestingly, that same research found that if there was increased distance put between both rewards, if we are looking at the choice between $50 in five years or $100 in six years, most people will opt for the more financially beneficial option, choosing $100 in six years.  This is part of the ‘hyperbolic’ aspect of our mental process; there’s a much sharper drop off in perceived value in the near future (today vs. one year from now) than there is more distantly in the future (five vs. six years), even if the time period between the two events is the same.  (Besides showing the underlying false logic behind this process, it also illustrates a point we’ll use to make more logical decisions in the future.)

Hyperbolic Discounting Examples

-Most importantly for a blog about investing and saving, hyperbolic discounting causes people to value their current spending more than their future wealth.  As a result, given the choice between spending more today and investing more for tomorrow, most will opt for the former.

-Discounting future payments also causes people to opt for lump sum payments rather than defined periodic benefits, even if the defined benefits are much higher than the lump sum.  (I understand that there can be circumstances beyond the relative values of each type of payment that determine which method someone would prefer; this comment is more about people who look at $20,000 per year for 15 years vs. $100,000 immediately, and opt for the $100,000 without a reason other than it being a higher amount.)

-Opting to skip school or further training for an immediate job.  While it allows you to start earning money sooner, you’ll earn less over your lifetime than with more formal education; hyperbolic discounting of your future earnings potential strikes again.

Beating Hyperbolic Discounting

Remember how I told that when viewing the options several years in the future, people made the more logical choice?  That’s probably your greatest defense against hyperbolic discounting: put some distance between you and any of the options, so you don’t let the desire for immediate gratification overwhelm your common sense.  It might seem like a tough choice between spending money now and investing for the future, but imagine that you can’t use the money for a year; do you think you’ll still want to spend it?  If not, why do you want to spend it now?

Investing goes much the same way; it’s easy to rationalize putting it off until you’re older, or keeping the amount you invest as small as possible, but that leads to delays or avoidance of investing altogether.  Instead, try to take a longer term view, and look at what you could potentially have when it’s time to retire.  Would you rather have $1.9 million or $2.9 million in forty years?  (The difference between investing $4000 and $6000, respectively, and earning a 10% during that time period.)  How about choosing between $1.1 million and $2.9 million at retirement?  (The difference between starting to invest $6000 a year at 35 vs 25 years old, respectively.)  When you run some numbers to see your future net worth potential, it’s easier to see how relatively small sacrifices now can yield big returns in the future.

There, you know have a few mental tools to help you cope with hyperbolic discounting; the key is to try to repress the natural desire for immediate gratification and instead focus on the long term.  If you get skillful enough at doing so, you should be able to avoid the problems of hyperbolic discounting without any problem at all.

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