Latticework Of Mental Models: Hyperbolic Discounting

Last year I decided to get a brand new laptop for myself. This got me started on the herculean task of selecting from thousands of choices available on numerous e-commerce websites.

After weeks of an excruciating process of comparing, shortlisting, and researching, I finally zeroed in on my final choice. Then started the wait for online discounts.

Very soon, the so-called online-sale-season arrived which offered a ‘whopping’ Rs. 100 discount on my selection. So much for the patience! But for a self-proclaimed prudent consumer, it still was a good deal.

What happened next is pretty much the story of every online shopper. Just when I was about to place the order, I saw the option of same-day delivery for an additional Rs 100. Guess what I did? Yours truly didn’t hesitate for a moment to take the offer.

Ironically, I waited for a week for a small discount but when the time came for buying I couldn’t wait another day and forked out extra money just to get my toy immediately. What happened to my admirable qualities of patience and prudence?

A little research on Google revealed that the introduction of get-it-now temptation in the deal caused me to behave irrationally. The symptom of this behavioural bias goes something like this.

When I have agreed to wait for six days, I don’t mind waiting for one more day. Well, if I can wait for six, goes the rationale, waiting for seven shouldn’t be a big deal!

But when I am told that I can get something today instead of tomorrow, my temptation refuses to wait for another day.

Scientists, as usual, have a name for this tendency – Hyperbolic Discounting. I am not going to explain the meaning of a hyperbolic function by drawing some fancy graphs. That’s beyond the scope of this post and my abilities.

‘Discounting is hyperbolic’ simply means a reward that is very close gets drastically more attractive. In other words, the closer a reward is, the higher our ‘emotional interest rate’ rises and the more we are willing to give up in exchange for it.

I hope you understand that for most humans, including me and most probably you too, this behavioural quirk comes ingrained in the psyche. It’s the way nature has wired us, an outcome of evolutionary process. So don’t feel bad.

In his book, The Art of Thinking Clearly, Rolf Dobelli writes –

Hyperbolic discounting, the fact that immediacy magnetises us, is a remnant of our animal past. Animals will never turn down an instant reward in order to attain more in the future. You can train rats as much as you like; they’re never going to give up a piece of cheese today to get two pieces tomorrow.

Think drugs, tobacco, alcohol, pizza, sitting on the couch or even investing in bad businesses in the expectation of making a quick return – we are all looking for quick fixes – things that make us happy now.

The habit of procrastination is hyperbolic discounting in disguise. I think it’s fair to say that we are impatient in the short run and patient in the far away future.

In fact, if you are struggling with your habit of procrastination, it’s because of your tendency to seek pleasure in short term rewards. Tom Stafford argues that technology and instant communication is exacerbating this bias. He writes –

…think of a time you didn’t check your email for a week. If you’re like me, you probably opened your email expecting lots of exciting news – a sum of all the excitement you experience with each individual email. But actually, a week’s worth of email isn’t very exciting.

The interest that email generates as you see it arriving in your inbox is an illusion generated by hyperbolic discounting. Every technology has its own logic, and part of the logic of email is the speed with which it is delivered, with the new mails always pushing their way to the top of the pile. This pull is as insidious as it is intense – apparently 59% of people surveyed by AOL are so addicted to keeping track of their email that they check it in the bathroom.

This is what makes me think that the very speed of email delivery is a handicap – email delivered with a half-hour delay would be easier to judge at its true value, and so be far less distracting.

Daniel Kahneman describes an experiment in his book Thinking, Fast and Slow –

In one of the most famous experiments in the history of psychology, Walter Mischel and his students exposed four-year-old children to a cruel dilemma. They were given a choice between a small reward (one cookie), which they could have at any time, or a larger reward (two cookies) for which they had to wait 15 minutes under difficult conditions. They were to remain alone in a room, facing a desk with two objects: a single cookie and a bell that the child could ring at any time to call in the experimenter and receive the one cookie.

…About half the children managed the feat of waiting for 15 minutes, mainly by keeping their attention away from the tempting reward.

This experiment on kids was repeated numerous times under different conditions. Here’s one version which was repeated using marshmallows.

Click here if you can’t see the video above.

The more interesting part of this experiment was that the participating kids were monitored until their adulthood. Kahneman writes –

Ten or fifteen years later, a large gap had opened between those who had resisted temptation and those who had not. The resisters had higher measures of executive control in cognitive tasks, and especially the ability to reallocate their attention effectively. As young adults, they were less likely to take drugs. A significant difference in intellectual aptitude emerged: the children who had shown more self-control as four-year-olds had substantially higher scores on tests of intelligence.

So there does seem to be some correlation between abilities to delay gratification and future success.

Your Money and Hyperbolic Discounting

Peter Bevelin, in his masterpiece book, Seeking Wisdom writes –

We give more weight to the present than to the future. We seek pleasure today at a cost of what may be better in the future. We prefer an immediate reward to a delayed but maybe larger reward. We spend today what we should save for tomorrow. This means that we may pay a high price in the future for a small immediate reward. For example, we buy things we can’t afford on credit cards.

According to Einstein, compounding is the eighth wonder of the world. It isn’t surprising that most people don’t really understand the power of compounding and that’s the reason they usually find themselves on the wrong side of the compounding equation i.e. the losing side.

If you could compound your money at the rate of 15 percent per annum for 25 years, it would turn your initial investment to 33 times its original size. Imagine what compounding (negative) can do to your wealth if you started losing money at the rate of 15 percent per year? Consumer debt is the number one reason for people facing financial troubles.

For some reason, human mind can’t intuitively grasp the power of compounding, neither for its benefit nor as a source of financial disaster. But you don’t have to be an Einstein to figure this out on your own. At least now that I have told you!

The irony is that many people, in spite of knowing this, will still fall for the trap created by high-interest consumer debt. Hyperbolic discounting is an instinct which is tough to overcome and financial institutions know that.

Banks that offer consumer loans and many credit card companies build their businesses largely by exploiting hyperbolic discounting. Borrowing money and paying interest are actions which spend future resources for benefit in the present.

With an easy availability of credit, hyperbolic discounting has created an environment where people hardly think about saving up for expensive items, even if it means paying exorbitant interest rates. No wonder in today’s society instant gratification is fuelled by misleading marketing messages by financial institutions that don’t shy away from exploiting our must-have-now instincts.

In Investing

When it comes to investing, nobody can describe this idea better than Warren Buffet, who wrote in his 2012 letter to shareholders –

Investing is often described as the process of laying out money now in the expectation of receiving more money in the future. At Berkshire Hathaway we take a more demanding approach, defining investing as the transfer to others of purchasing power now with the reasoned expectation of receiving more purchasing power — after taxes have been paid on nominal gains — in the future.

More succinctly, investing is forgoing consumption now in order to have the ability to consume more at a later date.

During Safal Niveshak workshops, Vishal and I meet a lot of tribe members who confess to having started in the stock market before realizing the importance of value investing. Many of them first dabbled into short term trading, speculating, derivatives and leverage (all of them being a manifestation of hyperbolic discounting in investing).

Since human beings began investing, they have been searching for a magic formula or easy recipe for instant wealth. It’s in human nature to seek instant gratification.

Another interesting way this bias comes in the way of rationality is our tendency to give disproportionate weight to recent (and easily available) information. It’s also called Recency Bias or Availability Bias.

Investors get carried away by short-term and recent developments in an industry and assume that it can offset and even override the long-term characteristics of the business. Effectively, people tend to discount the recent data hyperbolically.

When a company declares good profits for a quarter, after five years of poor performance, is it a sign of a turnaround? Perhaps yes but don’t forget what Warren Buffett says, “Turnarounds seldom turn”. Which means you should think about hyperbolic discounting before relying too much on the latest developments.

Conclusion

Steve Job’s idea, looking in the mirror and asking “what would I do if this was my last day on earth”, has been taken too far and in the wrong direction especially when it’s used by the youth to justify their inability to delay their gratification.

Before I end this post, I would like to leave you with this thought from Yuval Harari, who in his book Homo Deus, writes …

The traditional view of the world as a pie of a fixed size presupposes there are only two kinds of resources in the world: raw materials and energy. But in truth, there are three kinds of resources: raw materials, energy and knowledge. Raw materials and energy are exhaustible – the more you use, the less you have. Knowledge, in contrast, is a growing resource – the more you use, the more you have. Indeed, when you increase your stock of knowledge, it can give you more raw materials and energy as well. If I invest $ 100 million searching for oil in Alaska and I find it, then I now have more oil, but my grandchildren will have less of it. In contrast, if I invest $ 100 million researching solar energy, and I find a new and more efficient way of harnessing it, then both I and my grandchildren will have more energy.

So the best investment of time is to invest in knowledge. I hope the time you invested here today, in learning another mental model, would yield good results tomorrow.

Take care and keep learning.