18.11.

23, 19:57 Human Nature #16: Hyperbolic Discounting – Wiser Daily

Wiser Daily

Human Nature #16: Hyperbolic Discounting

Posted on October 4, 2016 by David Shahrestani, CFA

Imagine that we are given the choice between receiving $100 today or $200 tomorrow. The answer seems obvious, we should wait a day and get that
extra $100. But now imagine that the choice is between receiving $100 today or $200 in a year. The answer seems less obvious. As the waiting time
increases, the importance of that extra $100 decreases.

Statistically, when people are given the second option, they overwhelmingly choose $100 today. When those same people are asked again to choose
between $100 in five years or $200 in six years, their preferences flip again, preferring to wait the extra year for the extra $100. They assume that they
will be fine waiting in the future even though they aren’t fine waiting today. In reality, when year five rolls around, they will probably want the
immediate payoff as much as they want it today.

These conflicting preferences tell us something about the inherent irrationality in how we deal with the future.

Temporal Myopia

We tend to suffer from a type of temporal myopia – a decrease in clarity as time periods increase. This causes us to agree to commitments in the
future that we would not commit to today, it causes us to disregard preventative health measures in the present that would benefit us tomorrow,
and it causes us to sacrifice future monetary rewards for present gratification.

This time-inconsistent model of discounting the future is known as hyperbolic discounting – the farther away the awards or punishments are, the
more we discount them. This can also be thought of as the “I’m going to die anyway” approach to planning. In evolutionary terms, the selection
mechanism for traits is based on the ability to pass on genes from one generation to the next. If this can be done by your twenties, there’s little
incentive to select for qualities that plan for your eighties.

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Issues with Hyperbolic Discounting

There is an inherent conflict that we all face between short-term satisfaction and the achievement of long-term goals. When viewed through the lens
of hyperbolic discounting, the weight of short-term satisfaction increases while the weight of the long-term goals decreases. As such, most people
act in way that is not beneficial to their hyperbolically discounted long-term goals.

For example, when people are told that smoking will damage their ability to breathe in the future, most people see the short-term satisfaction of
smoking as outweighing the long-term ability to breathe. Similarly, studies have found that when heart attack patients were told to make a lifestyle
change or risk heart failure, only 10% of the patients sampled made any changes. If it’s in the future, what does it matter.

For another example, most people know that they need to save for retirement but still have difficulty sacrificing present consumption for future
consumption. An extra TV today is nice, even if it wreaks havoc on the long-term. This is the business model of credit card companies. Benefits
upfront, large costs deferred.

In both examples, a small benefit today is being exchanged for large cost tomorrow. Rational behavior would suggest that people would not pay
these out-sized costs for relatively small rewards, but they do. At the extreme, you can think of global warming. Sure the world might be inhabitable
in 50 years, but that is in 50 years. What pay a dime today?

Conclusion

People disproportionately value the present over the future. This causes problems when we try to rationally compare the costs and benefits between
time periods. A benefit might be huge on an absolute scale, but it will still be disproportionately punished the longer it takes to realize. Seinfeld
summarized it best:

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References:
https://en.wikipedia.org/wiki/Hyperbolic_discounting (https://en.wikipedia.org/wiki/Hyperbolic_discounting)
Posted in Human NatureTagged Cognitive biases, Emotional Biases, Human Nature, Hyperbolic Discounting, Self Control Bias, Temporal Myopia

Published by David Shahrestani, CFA

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18.11.23, 19:57 Human Nature #16: Hyperbolic Discounting – Wiser Daily

"I have the strength of a bear, that has the strength of TWO bears." https://www.amazon.com/Navigating-Street-Better-Approach-
Investing/dp/1098356403 View all posts by David Shahrestani, CFA

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