The perils of discounting future rewards for instant gratification

The perils of discounting future rewards for instant gratification
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First Published: Sun, Nov 23 2008. 09 33 PM IST

Not counting costs: A file photo of a bank in New Delhi. With credit easy to get, people tend to prefer immediate pay-offs to long-term benefits. Amit Bhargava / Bloomberg
Not counting costs: A file photo of a bank in New Delhi. With credit easy to get, people tend to prefer immediate pay-offs to long-term benefits. Amit Bhargava / Bloomberg
Updated: Sun, Nov 23 2008. 09 33 PM IST
Let’s say you win a Rs1,000 bet with your friend. Your friend, who is honourable and trustworthy, makes you an offer. You can either take Rs1,000 today or if you are willing to wait until tomorrow, he will pay you Rs1,001. Which of the two options would you pick?
Not counting costs: A file photo of a bank in New Delhi. With credit easy to get, people tend to prefer immediate pay-offs to long-term benefits. Amit Bhargava / Bloomberg
If you are like most people, you’d rather have your Rs1,000 today than wait another day to earn that Re1 “interest”. What we fail to realize in the process is that the Re1 interest actually amounts to a 36.5% rate of interest! When framed this way, the decision to take Rs1,000 today seems short-sighted.
While this example is a bit extreme, people demonstrate behaviour in their day-to-day lives that is similar to the one illustrated in this example. We discount future rewards so heavily that instant gratification becomes a preferred alternative even when waiting for the reward is a more rational alternative.
The bias that leads us to over-discount the future is referred to as “hyperbolic discounting” and it can lead us astray. The problem with hyperbolic discounting is that the discounting gets steeper and steeper as the reward pay-off date is pushed further out into the future. This makes it very difficult for people to make the right choices today for pay-offs that are many years away.
For example, when a community is examining the benefits of spending Rs1 crore now on reducing some emissions that will have a significant positive effect 20 years down the line, the benefits can get discounted to a point where investment in the pollution control apparatus may seem unattractive.
Interestingly, the negative effect of hyperbolic discounting on decision-making has been looked at in a variety of contexts, including how we view decisions about our own health and well-being.
Doctors find that even people who have had heart bypass surgery do not take all the measures they need to in order to significantly reduce the likelihood of future cardiac complications. The allure of that juicy burger right now is too much to overcome against the distant benefit of better health.
In this case, people are discounting their future well-being to an extent that they prefer choosing immediate pay-off in terms of unhealthy foods and behaviour over the long-term benefit of better health.
Hyperbolic discounting takes on a more sinister significance as the use of credit cards and loans increases. With easy access to credit, people find it convenient to get an immediate pay-off in exchange for long-term costs. Banks that issue credit cards with high interest rates thrive on this tendency of people to discount the future.
Why wait to save for that fancy, fully loaded Skoda when you can have it now and pay for it over the next six years? What we discount heavily at the time of purchase is the future pain of making those hefty monthly payments several years down the line.
Managers need to recognize this bias as they make decisions today that may have an impact in the future.
When the decision involves a short-term cost with a long-term benefit, try and put yourself in that future and consider whether the positive impact would have been worth the initial investment. That is, instead of standing at the point of the cost and looking into the far future at the potential benefits, reposition yourself at the point when you’re reaping the benefits of the investment and looking far back into the past at the costs.
In some situations, this “looking back” approach may deter you from making unwise investments. Think about how you would feel five years from now, driving a five-year-old depreciated car and still paying thousands of rupees a month to pay off that loan you took to buy what was then a fancy car. You may decide that the loan is not worth it.
Send your comments to driversseat@livemint.com
Praveen Aggarwal and Rajiv Vaidyanathan are professors of marketing at the Labovitz School of Business & Economics at the University of Minnesota Duluth. Aggarwal also serves as head of the marketing department, and Vaidyanathan is director of MBA programmes at the University of Minnesota Duluth.
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First Published: Sun, Nov 23 2008. 09 33 PM IST