Hyperbolic discounting: It’s now vs. the future, and it’s not a fair fight

“Hyperbolic discounting” is one of those terms that sounds more impressive than it is. People make weird – but oddly predictable – decisions when balancing today’s desires against tomorrow’s needs.  As a concept, however, it’s quite powerful. There’s a pattern to your bad choices.  Understand that pattern and you can change it.  I examined hyperbolic discounting recently in a piece for PeopleScience.com. You can get a flavor of it here; please visit the site to read the entire story.

Ice cream or salad? The couch or the gym? The new car or the 401(k)? These are questions we all face constantly, and most of us wouldn’t care to admit how often we arrive at the wrong answer. Each of these dilemmas has something in common – they are a trade-off between today and tomorrow. How do we decide? We make a bargain in our heads, using something sort of like a formula to weigh the value of today’s pleasure vs. tomorrow’s pleasure.

Quick: Would you prefer $50 today or $50 a month from now? That’s easy. Money tomorrow is not as valuable as money today – the delay causes you to mentally “discount” the value. Now a new question: Would you prefer $50 today or $100 a month from now? Not so easy. Your choice says a lot about how much you value both time and money.

Economists often call the mental calculation you use to make such a choice “discounting.” Plenty of factors go into this discounting formula, and they can be very personal. A $50 bill today might mean the world to some people and mean almost nothing to others. Maybe you’d take $100 a month from now, but if I made you wait three months, you’d take the $50 today. But if I offered you $200 in three months, perhaps you’d hold out for that. Behaviorist scientists enjoy observing how people play with these numbers. (Editor’s note: Are behavioral scientists thoughtful observers of human nature or sadistic freaks? Your choice says a lot about how you value my editor’s notes.)

It’s long-accepted wisdom that people who are “good” at discounting – good at delaying gratification – are good at lot of other things in life. If you can wait 30 days and double your money, you probably make healthier eating choices, too. On the other hand, being “bad” at discounting has been linked to other negative behaviors, like drug addiction and obesity. (Editor’s note: See also “Putting the Marshmallow Test to the Test.”

Another term used to describe this phenomenon is “present bias.” People who can only think about today often suffer dire consequences in the future. This all sounds simple enough, as eating too many desserts can have dire consequences within a few hours in the bathroom, let alone within a few years in the doctor’s office. One might think that the choice between some money today or some extra money tomorrow would follow a pretty straight line. Using my earlier example, perhaps you’d need $50 extra to wait each month – so you’d take $50 now, but no less than $100 in a month, or $150 in two months, or $200 in three months, and so on.

Humans are not so easily predictable, however. Let me change the question slightly. Would you rather I give you $50 in 12 months or $100 in 15 months? That’s a slam-dunk, right? You’re waiting 365 days anyway, what’s another 90 days?

Now, imagine I showed up on day 365 and asked you the same question again. You’d probably change your mind and take the $50. On the surface, this makes no sense, as the second offer is basically the same as the first – wait 90 days to double your money.

So what’s going on?

In simple terms, the calculation you use to discount money over time doesn’t follow a straight line. The farther in the future, the more your brain kind of says, “It’s all the same.” And if I plotted your preferences on a graph, it wouldn’t look like a straight line, or even an exponential curve you might remember from high school. Instead, it would be a curved line – a hyperbola – the kind you could have encountered in beginning calculus.

The calculation you use to discount money over time doesn’t follow a straight line.

The academic term for this is hyperbolic discounting. On the surface, this might seem foolish. If you’d wait three months for $50 extra dollars next year, why wouldn’t you make the same decision today? That’s irrational!

Perhaps. But there are those who think hyperbolic discounting has gotten a bad rap. After all, tomorrow isn’t guaranteed to any of us. There is a risk associated with waiting for a reward. What if you don’t trust me so you think I’ll back out of my offer in a year? What if one of us dies? Or something terrible happens to the value of the U.S. dollar? People make mental risk calculations all the time, and that’s part of this discounting formula.

It’s not just people: Hyperbolic discounting has been observed in pigeons, monkeys and rats, too. The fight for immediate survival can be pretty rational.

In the end, what really matters is being aware of the trade-offs you are making and how you calculate the costs. Sometimes that piece of cake really is worth the extra time you’ll have to spend on the treadmill — some calories are worth it. (Editor’s note: What kind of cake?) When you are buying a house, you are often trading a dollar today for nearly $3 at some future point (if you spend 30 years paying off your mortgage), and that makes sense, because you get to live in a nice house for 30 years. (Editor’s note: What kind of years? Human or dog?)

It’s easy to see how people can play games with your subconscious discounting formulas, however. Late-night ads that promise lump-sum payments for pensions or legal settlements – which often offer pennies on the dollar – prey on people’s inability to discount well. If you’ve done this, don’t feel bad: Entire states have done this repeatedly. Instead of taking many years’ worth of settlement payments from tobacco companies, for example, they “securitized” those payments with the help of Wall Street and accepted about 30 cents on the dollar to plug immediate budget gaps – future governors be damned.

The powerful tug of discounting can be used in plenty of ways, both good and bad. Employers looking to snag attractive employees can offer a sign-up bonus, paid immediately, rather than an end-of-year bonus. That’s more effective, and the company can probably pay a smaller bonus, too.

Discounting has impacts far beyond the financial world. For example: People often agree to far-off meetings or happy hours they don’t really care to attend because the consequences seem so distant. Then as the day approaches and the dislike for the event comes more real, they search for excuses to cancel.

Here’s a better approach: Always ask yourself “Would I say yes to this invitation if the event were today?” and respond accordingly. Doing so effectively eliminates hyperbolic discounting that might occur by bringing the question into the present.

Even better: imagine having to explain your choices to your future self. Could 45-year-old Bob justify buying that red corvette to 65-year-old Bob? Professor Hal Hershfield took this idea quite a bit further in one study. He actually showed subjects digitally altered images of themselves at retirement age. Not surprisingly, the subjects were more inclined to save money for this person they could now see.

Delaying gratification is hard enough, but a poorly tuned discounting formula can make things much harder. Becoming aware of the (slightly) irrational way you make decisions for your future self can go a long way toward finding the right balance between today and tomorrow, and that’s no hyperbole. Now that I’ve finished this story, I’m going to get myself a piece of cake. (Editor’s note: Seriously, what kind of cake, Bob? What kind of cake?!?)