Distant Elephants

If humans are offered two similar rewards, they will usually choose the one that comes soonest.  If they have to wait, they will want a little more.

We know, or at least psychologists and economists know, how that happens.  Future events are “discounted” to the present and compared to the current value or cost.

There are several ways to do it.  Economists and psychologists assume “exponential discounting.”  Much like finding the value of a bond.  Use some constant rate to discount the future amount back to the present.  It is rational, easy and efficient.  In a 5% world, $100 today, should be worth $105 in a year or $127.63 in 5 years.  These are all the same.

Nevertheless, like many theoretical constructs, not everyone uses exponential discounting, and no one uses it all the time or in all situations.

People who study this subject find that oftentimes people use “hyperbolic discounting.”

In this method, the first delay attracts a very high rate and as the time gets longer, the discount rate gets lower.  Maybe 20% for the first year and 6% for the second and 3% after that.  It sounds complicated but we use it more than we think.  Essentially, it means we live in a short time envelope and things not in the envelope are rendered unimportant.

Saving pays off tomorrow, spending pays off today.

If we discount the tomorrow value at a very high rate then we will always spend today because the present value of the future benefit is too low.  At 20%, $105 a year from now is only worth $87.50.  Even the 5 year result is only worth about $92.

Similarly, the pain to do a tax return is high.  Everyone promises to organize in early March and have it done by 1 April.  They never do, even though they know that leaving it to the last minute will be harder.  Here the discounted value of future pain is much less than the pain of current effort.  Procrastination has an immediate payoff.

Hyperbolic discounting applies to more than saving, spending or avoiding procrastination.  It insidiously affects decision-making.  It allows us to commit, too easily, to projects that start far in the future.  It is the distant elephant problem.

An elephant that you can see 4 miles away looks pretty small.  Not a threat.  Not a problem.  When the same elephant charges you from 30 yards away, it is a very big problem.  Same elephant, different context.

Like agreeing to become the fund raising chairman for the United Way two years from now.  That is much easier to agree to than if it were one year away or, horror of horrors, starting tomorrow.  Same current pat on the back; different meaning for the commitment.

Under hyperbolic discounting our present self makes decisions that our future self would not.  That is true even though the same assumptions are used by both selves.  And therein lies the problem.

There is not a lot we can do about discounting per se.  It works and our brains are hard-wired.  We can still have the wit to recognize it and learn to minimize its adverse effects.

Until tomorrow (discounted at a high rate)

4 Comments on “Distant Elephants

  1. Pingback: On Personal Budgeting | moneyFYI

  2. Pingback: “No” Is The Most Useful Word | moneyFYI

  3. Pingback: Present Self – Future Self – moneyFYI

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