It is reported that 71% of Americans express regret about their ability to handle their finances; the percentage rises to 83% among Millennials. The most common regret, expressed by 48%, is failure to plan early enough. Why does this happen? I will explain it using an element of our psychology called Hyperbolic Discounting. This is one of 150+ different sorts of Cognitive Bias. In my new book, I discuss the most important Cognitive Biases and how they will affect your investment performance (see link below).
So what is Hyperbolic Discounting and how does it explain our failure to plan early enough?
As with many Cognitive Biases, they have a kernel of value within them. This has to be true because otherwise we would not have them. They can be seen as “quick and dirty” heuristics which in most everyday situations are good enough to allow us to get by. If they are mostly right and avoid any scenarios of catastrophic error, then they probably do enough to pay their way in our mental architecture.
As an example, think of the widespread fear of snakes. Evolution could have aimed to give us only a fear of venomous snakes, but that would have been difficult to achieve and would have involved a risk of missing some snakes that could kill us. Better than this is to make people afraid of all snakes. The cost of that is that people will sometimes run away from some snakes that are harmless. But that’s fine. That cost is greatly outweighed by the benefits of avoiding the venomous snakes.
Hyperbolic Discounting is one of these sorts of mostly useful bias. It is founded on something like the common and accurate idea that “a bird in the hand is worth two in the bush.” In other words, something I have now is more valuable than something of equal value that I will have in a year from now.
This then raises the question of how to compare the present value of an item I now own and the present value of something I will own a year from now. This means applying a discount to the future item to account for the delay between now and when I will own it. In a world of low interest rates, it is easy to forget this. But when they return to 5% a year, it will be a lot more clear that $100 now is worth 5% more than $100 in a year from now. Because I could save the $100 now and it would be worth $105 in a year from now.
Turning this around, I can work out what the present value of the future $100 by discounting it. This means multiplying it by (100/105). This comes to $95.24. (You can check this by adding 5% to it and getting back to $100.)
So 5% is the Discount Rate here. This is how you should discount a future certain $100 by under circumstances where the risk means that is appropriate. Now we come to the problem with Hyperbolic Discounting. It seems that our default discount rates are set way too high. We set far too much store by what we have in our hands now. This is also perhaps reflected in the way we are prepared to smoke and not go to the gym today. Those things are easy to do and carry only minor immediate costs. Smoking of course
carries an infinite cost at some point in the future because it will kill you. It is only through Hyperbolic Discounting that anyone can manage to smoke. Similarly, not going to the gym will kill you. But not today.
These and many other Cognitive Biases are who we are and explain much of our decision making. The approach I take in the book is to describe some of the financially significant ones and then explain how they play out in financial markets. Thus, by reading the book, you can obtain two key benefits. Firstly, you can look out for biases like Hyperbolic Discounting in your own thinking and correct for them. Secondly, and even more valuable, you can expect them in other market participants and trade accordingly.