Behavioral Finance by H. Kent Baker

Author:H. Kent Baker
Language: eng
Format: epub
Publisher: Oxford University Press
Published: 2019-03-09T16:00:00+00:00

What Is Hyperbolic Discounting and Why Is It Important?

Why do some merchants advertise “Buy now, pay later?” Why do some people carry large credit card debt at a high interest rate while investing for retirement at a lower rate of return? Why do many people fail to save for retirement? Why would someone prefer to receive $5 right now instead of $10 in a month? One answer lies with the daunting term hyperbolic discounting.

Hyperbolic discounting is the tendency to prefer a return sooner, even if it is smaller, than a return later. That is, people desire an immediate reward rather than a higher-value, delayed reward. Although hyperbolic discounting is a cognitive bias that defies logic and common sense, it is everywhere. Such behavior implies that impulsivity levels are higher when people focus on making decisions based on achieving short-term rewards. Alternative choices that result in a delay become less attractive than more near-term and inferior opportunities. Returning to a previous example, the reason so many people fail to save for retirement is that no immediate reward exists for saving for the future.

In the absence of hyperbolic discounting, an investor with a return expectation of 10% annually should be indifferent between having $100 now and $110 a year from now. Likewise, the investor should also be indifferent between receiving $100 in a year and $110 in two years. This relation is referred to as exponential discounting. However, this economic theory does not reflect how investors actually make choices. In fact, investors’ behavior is more associated with hyperbolic discounting, which indicates that an investor is more able to wait for returns when both payouts are in the future. In the scenario presented above, such behavior implies that an investor is more likely to wait two years for the $110 than wait one year for $100. Yet people are unwilling to wait the same length of time, one year, to receive $110 when they can get $100 today. Something about receiving money today trumps waiting for more money later.

Let’s take a look at a nonfinancial example of hyperbolic discounting that involves starting a diet-and-exercise program. People who are overweight may have a desire to improve their health. They may develop an exercise regimen and go on a diet. However, in the short term, they may forgo healthy choices in favor of unhealthy meals, stating that they will follow a stricter diet in the future. That is, people often splurge before starting a diet. Likewise, they may defer their exercise program due to immediate distractions. Thus, a disconnect occurs between long-term desires and the current willingness to achieve better health, as short-term decisions become inconsistent with the heavily discounted future benefits of healthier living.

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