Countering temporal discounting
By Michael Field, Product Development Manager at FedGroup
|Issued by: Headlines|
[Johannesburg, 31 August 2016]
I've spoken about the psychology of wealth creation and the insights that behavioural economics can offer into the investment and saving decision-making process, and looked at the intention-behaviour gap, which is synonymous with contemporary savings culture, says Michael Field, Product Development Manager at FedGroup.
Another one of the key influencing factors in this theory, according to behavioural economists, is the concept of temporal discounting. This concept, also known as the immediacy effect, delay discounting, time discounting, or time preference, refers to the tendency of people to discount the value of rewards they will receive in the distant future. The magnitude of this value discounting is also said to increase exponentially in accordance with the length of time before the reward is realised.
Interestingly, studies conducted by behavioural economists have linked this effect to the perception of "self" – a "disconnect" between what the present self believes will benefit the future self. This is the reason why setting a retirement savings goal and sticking to it can often be difficult, or why some people would rather save R5 today than gain R40 in 12 months.
Similarly, when given the choice between a comfortable retirement and a new car, too many of us choose the new car as it's a form of instant gratification that appeases the wants and desires of the present self. The positive effect of a comfortable retirement only benefits the future self, and is so far off that the present self can't adequately comprehend the value of it.
In his Economic Letter titled: "Some Empirical Evidence on Dynamic Inconsistency", published in 1981, behavioural economist and Professor Richard Thaler also demonstrated this discounting curve by comparing short-term preferences with long-term preferences. As an example, when offered a dollar today or three dollars tomorrow, or a dollar in one year or three dollars in one year and one day, a significant fraction of subjects in the study took the lesser amount immediately, but were willing to wait one extra day in a year to receive the higher amount. Individuals with such preferences are described as "present-biased".
Obviously, when given the choice of a new car now or not being homeless in a month, most people would choose to not be homeless. However, when the time-frame is extended 15-20 years, people who have a greater present bias aren't able to decide as easily.
A 2010 study by Stephan Meier and Charles Sprenger ("Present-Biased Preferences and Credit Card Borrowing". American Economic Journal: Applied Economics, 2(1): 193-210) also found that these types of people are more likely "to have credit card debt, and to have significantly higher amounts of credit card debt, controlling for disposable income, other socio-demographics, and credit constraints". This lends further support to the concept of time preference when it comes to making, spending and saving decisions.
The good news is this theory can also be used to our advantage. For instance, if someone chooses to escalate their annual retirement contributions on an annual basis, by more than inflation, at the fund inception stage, when the immediacy effect of the money being committed is lower, they are effectively agreeing to contribute more to their retirement savings over time.
Similarly, one could set up a future-dated lump sum transfer into an investment vehicle that will come off their account just after they get paid. This is often easier to commit to because there is no attachment to that 'future' money, and the time frame is long enough that the effects aren't really tangible. With this approach, investors are able to improve their future financial position through a better understanding of their own psychology.