We start this short article with two scenarios: consider your choice in each.
Scenario 1:
Which would you rather have:
- $100 today? or
- $110 in a month’s time?
Scenario 2:
Which would you rather have:
- $100 in 12 months’ time? or
- $110 in 13 months’ time?
In the first scenario, experimenters found that most of us would choose A, whereas in the second, most of us would choose B.
Why might that be so? After all, the scenarios are similar in that the respective reward delays are exactly one month apart.
It’s because of a phenomenon to which we are all behaviourally subject; its unwieldy name is ‘hyperbolic discounting’ (H-D).
This means that we are wired to prefer immediate rewards in preference to those deliverable later. However, our inclination towards deferred rewards decreases (we discount it) the further away in time the reward is to be delivered.
This gives rise to the term ‘hyperbolic’ in the double-barrelled expression: if we chart our preferred values, the curve becomes a hyperbola the further we extend the time axis (pictured).
Hyperbolic discounting is one of the most studied of all the behavioural biases with such economic luminaries as Shiller, Thaler, Fisher, Kahneman, et al. (In reading one research paper on the topic, there were no less than 120 end notes of references on the topic.)
Key Points
Simplification chart of H-D
We see the H-D phenomenon in myriad ways, from advertising (‘buy now, pay later’); to finance (credit cards encourage instant gratification but frequently at the cost of ruinous debt); and failed diet plans (the future slimmer body image may be heavily discounted when a tempting slice of cake is consumed as an instant reward). Psychologists are engaged to insert H-D effects in everyday experiences that, naively, we take for granted.
It’s tempting to spend $100 on (your preferred noun) now rather than invest for the longer term. But remember that the ‘Rule of 72’ indicates that, using just a 7% yield, money will double in 10 years.
The lesson for investors is to resist the impulse to gain a small reward now instead of a far larger one later; and to ignore the temptation to discount future values which, with a little discipline and sound portfolio management, may grow to very substantial sums indeed.
Warren Buffett expressed it well: “A person is sitting in the shade now because someone planted a tree a long time ago.”
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