What is... | January 31, 2012

What is hyperbolic discounting?

If you could choose to get €50 now or €55 a year from now, which would you pick? If you went for the immediate €50, watch out – you may be falling victim to the thinking trap known as hyperbolic discounting.

Is today more important than tomorrow?
Hyperbolic discounting is our tendency to consider the consequences of our choices less the further in the future they fall. For important events that lie a long way in the future – such as retirement – it can have big implications.
Monetary rewards such as the choice between €50 now and €55 a year from now are often used to illustrate hyperbolic discounting at work. Logically, a guaranteed 10% return on €50 is pretty good, so depending on individual circumstances, it could well pay to wait and take the higher sum. But as an earlier eZonomics poll showed, many of us choose instant rewards instead.

Is today very much more important than tomorrow?
A more widely known term is ”discounting” however hyperbolic discounting differs in that the speed of the discount is very quick over a short time and then slows. This is sometimes called a “time inconsistent” approach to discounting. The representation of this approach in a maths formula is said to be hyperbolic rather than exponential.
Research suggests that children discount more rapidly than adults – perhaps they find it more difficult to wait for rewards.

“A hyperbolic discounter behaves in a way that his future self will regret”
In a blogpost for eZonomics, economist Chris Dillow cited research from the United States which demonstrates how respondents gave time inconsistent responses when identical monetary rewards were offered but at different times in the future. Asked if they preferred €80 now to €100 in a year's time and €80 in five years' time to €100 in six, respondents tended to prefer the instant reward in the first scenario rather than wait a year but were prepared to wait a year in the second scenario.
Dillow warns this inconsistency and hyperbolic discounting can badly distort planning for pensions and savings. He writes that the person takes €80 today rather than €100 next year. Then tomorrow, another €80 is taken rather than €100 in 366 days' time, and so on.
“The person never gets around to choosing the €100 in six years' time over the €80 in five. The longer-term choice that his future self would want is never chosen. Too little is saved,” he says. “A hyperbolic discounter behaves in a way that his future self will regret.”

Imagine your life 30 years from now
Combat hyperbolic discounting by imagining your life 30 years from now. The eZonomics story Forward thinking tells how seeing an older version of yourself may help boost retirement preparations. In an experiment, people shown a version of what they might look like in the future put twice as much money into a test retirement account than participants who were presented simply with their mirror image.
So – as hard as it is – try to imagine being older or that an emergency, such as illness, has happened. It might help make the future more real and reinforce the importance the choices we make now will have in years to come.

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eZonomics team
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