“Hyperbolic discounting” makes us cruel to our future selves

We usually regard those who live for the moment with no saving plan as extravagant. But have you ever thought that they may be influenced by psychological biases? Let’s do an experiment:

Suppose you are going to receive a sum of money. Would you rather receive $800 now or $1,000 a year from now?

From a financial perspective, receiving $1,000 a year from now by investing $800 today means an annualized return of 25%, which is not an easy financial target to achieve. Therefore, taking $200 more a year later is the rational choice. However, research has found that most people prefer to take $800 immediately, favouring short-term interest over long-term benefits.

The trap of living for the moment

The trap of living for the moment

This experiment illustrates a behavioural bias called “hyperbolic discounting”, whereby people tend to choose a smaller-sooner reward over a larger-later reward. “Discounting” means discounting the value of a future sum to its present value. When analyzing financial issues, we may convert the value of a sum of money occurring at different times to one shared point (usually the present) when comparing the actual value difference. However, in everyday life, we rarely apply such calculations in our financial decision-making, relying instead on instinctive estimations. Influenced by “hyperbolic discounting”, we may over-discount long-term rewards, making them seem much less valuable than they really are.

When people think of the future, some tend to over-discount their post-retirement happiness and belittle its value. Meanwhile, they don’t discount any of their present enjoyment, preferring a “live for today” approach. To them, saving for a rainy day is worthless, and they see saving for retirement as unrealistic, and are even against it. However, our resources are limited, so living a lavish life in the present in a way means we are being cruel to our future selves. Since it only makes sense to value our present and future equally, we need to examine how to tackle our psychological biases to achieve this.

Save first for the future

Save first for the future

Everyone hopes to maintain their health and quality of life after retirement, but we all know that things don’t always work out the way we want. So when your present self makes key financial decisions in the present, you have to consider the impact on your future self. For example, would purchasing a new car now mean having less to spend on your future medical expenses? Would buying a brand-name handbag now stand in the way of realizing your dream of travelling with your partner after retirement? From now on, start planning sensibly for your retirement, based on the idea of looking after your future self.

Psychological biases are part of human nature and work subconsciously. They can’t necessarily be overcome by a “strong will”. The key to overcoming psychological biases is to build up a mechanism that protects your future by minimizing the chance of making irrational decisions. To accomplish this, a number of wealth management philosophies suggest saving before spending if circumstances permit. For example, save a portion of your monthly income and use the remainder for your everyday expenses. This way, you don’t have to worry about using up all your income before the end of the month because of impulse buying. When you make a habit of putting aside your savings first, you will find saving much easier.

The idea behind the MPF requirement of making a fixed contribution on a regular basis, as well as autopay monthly saving plans and deferred annuity products, is to take every opportunity to look after our future. Statistics show that as at the end of December 2017, there were about 50,000 MPF accounts with over $1 million in benefits, and 270,000 accounts with over $500,000! From now on, take better care of your MPF, and look after your future self!