Of Daniel Kahneman and why investors need the skill of delayed gratification

The ability to delay gratification can lead to long-term physical, mental as well as financial well-being.
The ability to delay gratification can lead to long-term physical, mental as well as financial well-being.

Summary

  • Kahneman drew on cognitive psychology to understand how people make economic decisions.

Daniel Kahneman, who died on 27 March, was best known for debunking the notion of ‘homo economicus’. Kahneman drew on cognitive psychology to understand how people make economic decisions. Kahneman’s work shed light on why it is so challenging to save and invest for the long term, why, despite the mandatorily displayed warnings, that 9 out of 10 traders lose money in the future and option segment, and scores of individuals, especially the younger generation, are drawn to derivative trading. Kahneman attributed this phenomenon to people’s struggle with decisions involving delayed gratification. He introduced the concept of ‘temporal discounting’, wherein future rewards are undervalued in favour of immediate satisfaction, leading to suboptimal financial choices and unhealthy behaviours.

Long-term investing rests on the skill of delayed gratification. The ability to delay gratification can lead to long-term physical, mental as well as financial well-being. Impulsive individuals find it difficult to evaluate all choice alternatives and their long-term consequences. Impulsivity is related to time preference. Individuals with a high time preference, i.e. present-time orientation, focus on the present and prefer to spend their money immediately rather than later. On the other hand, individuals with a low time preference, i.e. future-time orientation, are more willing to delay the gratification of having products and services immediately. They generally save and invest for the future.

In periods of economic upswing, people become more confident and optimistic about the future economic conditions and about their own financial situation. Their time preference shifts from low to high. As a consequence, they are more inclined to splurge than save and invest. The young generation with YOLO (you-only-live-once) and FOMO (fear-of-missing-out) mindset, seem to interpret the age-old wisdom of living in the present differently. For them, living in present means present time orientation and instant gratification. There has been a lot of debate and concerns on the widening gap between the have and have-nots. There is a third category that lies within the realm of the haves and the have-nots: the have-not-paid-for-what-they-have. People are saving less and spending more even if they need to borrow the money. The proverb ‘Better to go to bed hungry than to wake up in debt’ has become outdated. The biggest threat to long-term wealth creation is not the market volatility but the attitude of instant gratification. There is an opportunity cost of instant gratification. Every rupee spent on a non-essential current pleasure is a rupee not invested for the potential future wealth. Living in the present does not mean that people should not plan or work for future.

Shefrin and Thaler (1988) referred to the internal conflict between short-term and long-term preferences as a conflict between a ‘planner’ and a ‘doer’. The planner is assumed to be far-sighted and aims to strive toward maximizing life-long utility. The doer is myopic and impulsive, strives toward maximizing immediate benefits. Though people have an ingrained preference for doing things that make them feel better in the moment over waiting for rewards that may occur at some uncertain future point, an evolutionary trait differentiating humans from other species is to show patience, forgoing immediate benefits to acquire more valuable future rewards. Patience is a uniquely human trait. In order to satisfy long-term goals and objectives, it is necessary to exert self-control. Fortunately, delayed gratification for longer periods of time is a skill one can cultivate and practice. Individuals can adopt various strategies to defer immediate gratification. Methods such as segregating wealth into separate long-term and short-term accounts, enrolling in systematic investment plans (SIPs), National Pension Scheme (NPS), etc., are effective ways to accomplish long term investing.

However, leaving long term wealth creation, just as the problem of obesity, to the willpower of people could be a costly mistake. They are unlikely to be self-correcting. They are not just an individual’s problems. They have socio-economic consequences. The tendency of instant gratification and myopia will come in way of long-term capital formation.

People themselves, the financial services industry, issuers of securities and other financial and investment products, investment advisers and financial planners, the regulatory bodies and financial and business press have a significant role to play in shaping the choice architectures and decision-making environment to bring the needed shift in mindsets.

It is necessary to understand that reaping the benefits of compounding requires time, that time in the market is more important than timing the markets, and that delayed gratification is pivotal for accumulating wealth.

Rachana Baid is professor and dean (academics) at the National Institute of Securities Markets (NISM).

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