What is ‘hyperbolic discounting,’ and how can it save you money?

Wikimedia Commons
Wikimedia Commons

Money and time have a very funny relationship, and by funny, I mean, most people misunderstand it. For example: What’s more valuable to you: $10 today or $20 next month? Next year? The choice to spend or save money is a constant trade-off between having something today vs. having something tomorrow, but we are rarely trained to think about the time part of this equation.

A lot of exciting things are happening in the field of behavioral economics, which marries psychology and personal finance. New-age economists — often to the dismay of their classical brethren — are conducting studies which show that people often make irrational decisions when it comes to money. This isn’t a controversial notion: the phrase “a fool and his money are soon parted” dates to a 16th-Century poem. But some of their conclusions are controversial, as they threaten a lot of presumed wisdom about the nature of free markets.

But these controversial conclusions can also save you a lot of money.

So we are starting a new series here at Credit.com. Perhaps you’ve heard phrases like “endowment effect,” “anchoring” or “discounting.” Perhaps you even have some notion of what these things are. But somewhere between the academic papers and the theoretical arguing, the impact on your bank account can get lost. So we are going to translate these concepts for you, and show how they can save you time and money.

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So, back to time and money. Naturally, you’d rather have money today than tomorrow. Who wouldn’t?  If someone offered you $100 today or $100 in a year, you’d take the money today. Money in the future is worth less to you; you are “discounting” its value. In fact, if someone offered you $100 today or $101 in a year, you’d almost certainly take the money and run. You’d take less today than tomorrow, so real is that discounting effect. But there is an amount that would make you reconsider your choice. Maybe it’s $110 vs $100? Maybe it’s $150 vs. $100? Most certainly, it’s $500 vs. $100. That magic amount — which is different for everyone, and in fact, can change over time – is called a discounting rate. Economists like Joe Kable at the University of Pennsylvania actually run tests on consumers to pinpoint exactly what this rate is. Some people gladly take $18 next month over $16 today; others take $10 today instead of $50 in six months. Interesting? Perhaps only to economics geeks.

But here’s what the economists don’t say as loudly about discounting rates: Big corporations are MUCH better at discounting than most consumers are. And they make big bucks exploiting this gap.

Plenty of folks take $10 today over $20 next month, for example, which is completely irrational. They could get a pricey cash advance on a credit card to replace the $10, then take the $20 in a month, pay off the card, and come out way ahead. Heck, they could take that deal, then borrow $10 from a friend, promise to pay back $15, and still win.

But while consumers misunderstand such opportunities, corporations with good finance departments rarely do. Now, make a few million transactions like that a year, and you’re talking about real money.

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Let’s tweak the circumstances of the time-money choice and create a big change in decision-making. Say I offer you $100 in 10 years or $150 in 11 years. Most people chose the $150, and I bet you did, too, even though this decision is quite similar to the earlier quandary (waiting 12 months gets you an extra $50). That’s because both rewards come in the future, and you don’t mind waiting the extra time, since you have to wait anyway. You discount both alternatives. Now, if I give you a second chance to make the choice 10 years from now, you’ll probably take the $100 and run, again. Economists call this concept hyperbolic discounting.

How can you use the concept of discounting in everyday life? Discounting has direct and obvious implications for saving money. Would you rather have $50 this week or $50,000 at retirement? Make the right choice on that question every week, and you’ll have your $50K (if you are under 30).

The best mental exercise to help your decision-making is to imagine your “future self” as a real person, and have a conversation. After all, if you are under 30, you are going to have to explain to that 60-year-old where that $50 went. Some studies have shown that creating an artificially-aged image of consumers and showing it to them actually improves their ability to trade things today for things tomorrow.

This “ask your future self” exercise works beyond personal finance, too: other studies have shown that people who are good at imagining their future eat more healthy (they trade a cookie today for a slimmer waist tomorrow), and they are less likely to abuse alcohol or drugs (trading a high today for health tomorrow).

Another way to think of this time/money problem is to use a word your mother always used: Impatience. That’s what Theresa Kuchler did in a paper she published at the Stanford Institute for Economic Policy Research last year called “Sticking to Your Plan: Hyperbolic Discounting and Credit Card Paydown.” It measured consumers’ ability to set and stick to plans to pay off credit card debt. A group she termed as “naive” often spent money today, thinking they would make a better choice next month — when they would once again fail to listen to pleas from their future self. That’s hyperbolic discounting in action. It’s easy to promise to start saving next month. That seems less appetizing when next month arrives, so – sticking with the above example – people take the $100 and run.

The main lesson for you:  Of course, there is a time and a place for carpe diem. But whenever you find yourself trading something tomorrow for something today, take 10 seconds to think like an economist: Ask yourself, “Am I underestimating the value this money might have to me in the future?” It’s a healthy habit you’ll use every day.

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About Bob Sullivan 1524 Articles
BOB SULLIVAN is a veteran journalist and the author of four books, including the 2008 New York Times Best-Seller, Gotcha Capitalism, and the 2010 New York Times Best Seller, Stop Getting Ripped Off! His latest, The Plateau Effect, was published in 2013, and as a paperback, called Getting Unstuck in 2014. He has won the Society of Professional Journalists prestigious Public Service award, a Peabody award, and The Consumer Federation of America Betty Furness award, and been given Consumer Action’s Consumer Excellence Award.

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