Let’s begin with a simple dilemma: You are offered $100 today or $110 tomorrow. Which would you take?
With even a rudimentary understanding of finance, I suspect you’ll jump at the $110 tomorrow. “10% in a day?! Why are you even asking?”
But in practice, a substantial number think differently.
$100 now offers immediacy. It can be spent at our leisure as soon as we’ve accepted. $110 tomorrow may be promised, on the other hand, but it isn’t guaranteed. What if the offer is revoked? What if the person making this offer goes back on their promise, goes bankrupt overnight, or even dies? A bird in the hand is worth two in the bush.
Longstanding behavioural economics research tells us that this preference for immediacy wins round a significant portion. But as we change the parameters of our dilemma slightly, it becomes a little more nuanced than that.
Let’s say now that you’re offered $100 in 30 days or $110 in 31 days. Research suggests that of those who wouldn’t accept the terms before, a large proportion would now take the $110.
As we move this one-day difference further into the future, more and more would accept the $110 until there was nobody left standing in the $100 corner.
Psychologists and economists call this pattern hyperbolic discounting. And from our finances and productivity through to our health and relationships, it has some extremely important implications for our lives.
What Is Hyperbolic Discounting?
Put simply, hyperbolic discounting refers to the tendency for people to impulsively prefer smaller but sooner rewards over larger but further away rewards. But as we are forced to wait longer for rewards, our irrationality and impulsivity decreases.
Our tendency to “discount” rewards further in the future isn’t controversial. Delayed rewards are less attractive than immediate rewards. It’s normal that we should value them differently. What’s more, it’s correct that financial calculations discount for the effects of inflation over time.
But hyperbolic discounting has a unique difference to the traditional economic view when it comes to discounting. In true economist style, the best way to illustrate this difference is via a graph.
Exponential Discounting vs. Hyperbolic Discounting
Bear with me. That subtitle isn’t as scary as it sounds.
Let’s start with the traditional view. Homo economicus is our rational economic man. He discounts rewards by a fixed unit of time for each unit of time he waits. For example, for illustrative purposes, let’s say he discounts a reward by 20% for every 3 months he waits. In other words, $100 is worth $80 after 3 months, then $64 after 6 months, and so on.
In this view, known as exponential discounting, the percentage of discounting remains consistent. The only influencing factor that changes homo economicus’ valuation of the reward is the length of time and the constant discount rate. This result is a smooth exponential curve like the below.
Key Concept – Discount Factors: Discount factors are used as weightings to identify the present value of a future reward. We multiply our known future reward by the discount factor. For example, if our discount factor is 0.3 after 12 months and our known future reward is $100, we would multiply 100 by 0.3 to get a present value of $30 (granted, our illustrative case is an extreme example). The lower the discount factor, the more we are discounting.
But as we already know from our opening dilemma, the reality is a little different from homo economicus. In reality, the graph often looks more like the dashed line below. On this line, people discount future rewards at a higher rate when they occur sooner in time. Psychologists suggest this phenomenon is driven by temporal myopia: an inability to properly consider the long-term outcomes of choices.
But as we move a choice further along in time, something interesting happens. Impulsivity decreases and our curve starts to flatten. Put another way, as rewards move further into the future, we become more patient and logical in the face of the same choices. We are more willing to defer gratification in the future than the present.
Research supports this idea. When given a choice between two future rewards, studies have shown that people are more likely to choose the larger one, even if it will come later.
Examples of the Hyperbolic Discounting Effect
If you haven’t figured yet, this isn’t just some behavioural science quirk that looks pretty on a graph. Hyperbolic discounting has profound implications for how we live our lives – and how we can improve them.
Take your personal finances. Our discounting can contribute to the decision to purchase for immediate gratification now instead of investing for later, leaving many underprepared for retirement.
Or take that upcoming project. Discounting the future reward of completing it can leave us procrastinating and kicking the can down the road. By the time we recognise that we’ve excessively discounted its rewards, we can’t deliver the best project outcome possible.
The same is true of our health. Diets and exercise can become a discounting trade-off between next year’s you and today’s you. Too often, healthy habits fall down because today’s you is victorious over next year’s you.
In short, hyperbolic discounting can have a profound negative impact on our lives. But the good news is that the reverse is therefore true of understanding and overcoming it.
How to Manage Hyperbolic Discounting
#1: LEARN: Build awareness of the concept
The first key to overcoming a thinking error is understanding it. Awareness of hyperbolic discounting triggers the process of asking our self the right questions when presented with dilemmas between present and future.
Knowing that we have an irrational but predictable tendency to excessively discount long-term rewards versus present rewards can be the push required to better visualise our future selves. Put another way, awareness can be like a pair of glasses, improving our long-distance vision while correcting our temporal myopia.
#2: SUBTRACT: Automate your choices
Forgive me for stating the obvious, but we can also avoid the perils of hyperbolic discounting by confronting less of these dilemmas in the first place. We don’t do that by hiding away and avoiding the big choices; we do it by automating them. When we automate, we subtract by making a sound decision once and then letting a machine repeat it for us in the future.
Automation is highly effective because it embraces another predictable element of human psychology: our fondness for the status quo. Once something becomes the default path, we are much less likely to deviate from that choice.
Case in Point: Don’t believe me? Just take the example of pensions. As companies have moved from defined-benefit to defined-contribution plans, governments have looked at how they can better encourage employees to save for their futures. In work that set the precedent for part of his book Nudge (UK, US), Richard Thaler teamed up with Shlomo Benartzi to assess the effects of such defaults. Workers agreed in advance to save a larger percentage of their salaries after their next pay rise. The result? They found that as the workers stuck at their new default savings plan, average saving rates increased from 3.5% to 13.6%. This is the power of the status quo in action.
#3: REWARD: Create short-term incentives
But we cannot automate all our choices, of course. Where automation isn’t possible – or would simply be an unwise choice – we must accept our tendency to discount and design a system that embraces it. We can achieve this first through breaking down our long-term goals into shorter-term goals, and second through creating a short-term reward system.
Let’s say for example that the long-term goal is to run a marathon. If we leave that goal as “run a marathon”, we’re likely to rapidly discount it until there is scarce motivation left. What we need are short-term training goals, and rewards to go with them.
There are two particularly useful strategies here:
- Temptation bundling: When we’ve completed the short-term goal, we stack on a habit that brings us pleasure. For example, once you’ve done your 10K training run, you might watch Netflix or go for a drink with friends. The key point is that the latter is dependent on the completing the former. By stacking on a more enjoyable habit, we are tapping in and editing our normal discounting calculations.
- Visual tracking: The process of tallying off each short-term goal as it is completed is itself rewarding. Visualising our progress can help maintain motivation and gives us another satisfying habit to work alongside the short-term goal.
#4: COMMIT: Use other commitment devices
If automating doesn’t do it, and your reward system isn’t enough, you can always try to lock yourself into the decision through a commitment device. This creates pressure to complete an action or set of actions by giving yourself a reward or punishment. If we fail to follow through on our choice, a commitment device carries consequences with it.
One effective strategy in practice is to develop a social contract. In the case of our marathon trainer, a useful social contract would be regular training sessions with an exercise partner. Adding the social pressure of feeling like you’ve let someone down can provide powerful impetus to stay on track.
Valuing Your Future Differently
If you take one thing from this article, make it this: we don’t always value future rewards rationally. Check yourself before jumping at immediate gratification when presented with a dilemma between now and later.
As you begin to ask more questions of yourself, you’ll begin to better empathise with your future self. And as you begin to empathise with your future self, you’ll start valuing your future differently.
- Hyperbolic discounting is the tendency for people to impulsively prefer smaller but sooner rewards over larger but further away rewards.
- As we are required to wait longer for rewards, we are more willing to defer gratification.
- The risks of hyperbolic discounting are pervasive in day-to-day life.
- To combat against this cognitive bias, we can benefit by building our awareness of it, automating decisions where sensible, creating short-term incentives, and using commitment devices.