What is... | February 11, 2014

What is present bias?

When a new year dawns, many of us resolve to improve our lives. We might promise to give up bad habits, pay more into a retirement fund or cut credit card use.

New Year resolutions are a popular tradition in many countries. But just a few months into the new year, often these good intentions have weakened and we’ve put the plan to increase the retirement fund on ice, paid for an impromptu dinner on the credit card and are enjoying “the now”. This behaviour is symptomatic of what is known as “present bias”. Present bias is the tendency to over-value immediate rewards at the expense of our long-term intentions – a trait that can have big implications later on.

A classic test
There is a well-known experiment that exposes this present bias tendency. Participants choose whether they would prefer, for example, EUR160 in a year or EUR150 in 48 weeks – then choose between EUR150 today or EUR160 in four weeks.

Participants often have no problem choosing the higher figure for the distant future but find it hard to be patient when the smaller amount is right in front of them.

However, both options essentially present the same situation. In both cases it’s a choice between EUR150 sooner or EUR160 four weeks later – if you prefer EUR150 now you should also prefer it in 48 weeks. Nonetheless many people display present-biased preferences by waiting for the extra cash when there is the year-long gap but taking the smaller amount now.

Present bias is related to the thinking trap known as hyperbolic discounting. The difference is that hyperbolic discounting is “time inconsistent” because its effects apply quickly over a short time and then slow down.

Emotional and impulsive?
A famous 1996 paper by behavioural economics expert George Loewenstein described how visceral states (such as hunger or strong emotions) can profoundly affect decision making in ways that are not in people’s long-term interest. Known as ”hot states”, it is because temporary emotions can have such a distorting effect on our behaviour that “cooling off” periods exist for many significant purchases.

Savings goals, in particular, can be hard to maintain when advertisements evoke strong emotion and encourage spending. Of course, emotions aren’t the only factor influencing present bias – age, gender, cultural background, education and self-control all play a role in discounting decisions – but they are a factor that can be managed more easily than the others.

The demeanour of oil magnate John D Rockefeller springs to mind here. Rockefeller frequently clashed with business partners during his career in Standard Oil and whenever they impetuously offered to sell their shares and leave the company, he would calmly reach into his pocket and write them a cheque. His cool temperament and willingness to take the long-view helped him become the richest person of all time (in real terms).

Reducing present bias with friends
Traditionally, the lever in economics used to encourage savings is the manipulation of interest rates. If you want people to save, simply offer them higher interest.

However studies in behavioural economics have found more creative ways to reduce present bias and encourage saving. One study examined a two-year experiment with 2,700 people in Chile that tested the effectiveness of weekly self-help peer groups, text message reminders and the more traditional approach of a high interest account that paid 5% (instead of 0.3%).

Surprisingly, the study found the 5% interest rate had no effect on most people. But those in the peer groups (which involved announcing their savings targets to other members) deposited money 3.5 times more often and weekly text message reminders (operating like a virtual savings buddy) were almost as effective. In the real world, we can try to combine the power of peer effects and regular reminders by sharing our goals with friends, like the peer group, and asking them to regularly monitor our progress.

Reducing present bias with commitments
Another study in Malawi tested whether ”commitment accounts” could help farmers to save. The farmers deposited their money in these accounts and designated a certain date when they could withdraw it – essentially denying themselves access to their own money.

The farmers who used these commitment accounts ended up with considerably more savings to draw on when the time came to buy seeds and fertilisers. They had avoided present bias by not having the cash on hand to give in to temptation in the now. It is similar to the Christmas clubs that operate in many countries with the aim of providing a way to lock away savings earmarked for the festive season until the holidays arrive.

Another way to put this research to use is to have a certain percentage of your salary automatically transferred to a savings account for a goal and timeframe that suits your ambitions and restrict your own access to it.

Reducing present bias by seeing your “future self”
Lastly, an experiment in 2011 used a novel way to get people to understand the importance of saving for retirement by making their “future self” more realistic to them now. The faces of the study participants were digitally scanned and altered to create a realistically aged version. The participants were then given a hypothetical choice regarding their preferred retirement allocation.

Those who saw an image of themselves in the future consistently chose to put more of their savings aside. If the film Minority Report was really an accurate prediction of what advertising will look like in the future, perhaps people in 2040 can expect to see wizened holograms of themselves when walking by behaviourally-savvy insurance companies.

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EconomicsSavingPersonal financeEmotionRetirement

Mark Egan

Behavioural science consultant