"An investment in knowledge pays the best interest." — Benjamin Franklin
(5-minute summary of this article)
If you read this newsletter, you can expect to:
Discover why your brain is more "hare-brained" than you'd like when it comes to financial decisions
Learn how our caveman instincts are sabotaging your retirement plans
Uncover the psychological trickery behind why you'd rather have a shiny new phone now than a gold-plated walking stick in your golden years
Master the art of outsmarting your own brain to make better long-term financial choices
Grasp why buying in bulk isn't just for doomsday preppers, but for savvy savers too
In the heart of Whispering Woods, where the trees grew tall and the rivers ran deep, there lived two unlikely friends: Terrance the Tortoise and Harry the Hare. They were an odd pair - one slow and steady, the other quick and impulsive. But they shared a common dream: to build the most magnificent burrow in all the forest.
One day, as they were gathering acorns, the sacred forest currency, they stumbled upon a most peculiar sight. At the base of an ancient oak tree stood Owl, the woods' wisest resident, next to a strange, glowing acorn.
"Gather, children" Owl hooted. "I see you've noticed my time-bending iridescent acorn. It's quite the marvel. Any acorn placed next to it will multiply tenfold in exactly one year. But beware, for time is a trickster, and once your decision is made, there's no going back."
Harry's eyes lit up with excitement. "Tenfold in a year? That's amazing! We could build our burrow in no time!"
Terrance, however, looked thoughtful. "But a year is a long time to wait. Are you sure it's worth it?"
Owl smiled enigmatically. "That, my friends, is for you to decide. Choose wisely, for your future depends on it."
With that, Owl flew off, leaving Terrance and Harry to ponder their options.
Harry, always quick to act, gathered all his acorns - a modest pile of 10 - and placed them next to the glowing acorn. "Just think, Terrance! In a year, we'll have 100 acorns! We'll be the richest animals in the forest!"
Terrance, true to his nature, took his time to consider. He had saved 50 acorns over the years, far more than Harry. But the thought of parting with them for a whole year made him hesitate. "I don't know, Harry. A lot can happen in a year. What if we need these acorns before then?"
In the end, Terrance decided to keep his acorns, planning to use them for smaller improvements to his current home. Harry, on the other hand, dreamed of the lavish burrow they'd build with his future 100 acorns.
As the seasons changed and the forest cycled through its annual dance of growth and rest, our two friends faced the consequences of their choices...
—
The Psychology of Temporal Discounting
Once upon a time, economic theory was dominated by the assumption that humans were purely rational decision-makers, always calculating the optimal choice with clinical analysis and dispassionate rationality. The field of behavioural economics was born out of the simple but breathtakingly obvious observation that human beings were not cold-hearted decision machines evaluating all possible permutations before arriving at an optimal solution. The prevailing wisdom shifted to then consider that human beings were more than capable of stumbling over their own emotional baggage and subjective biases on the way to making sub-optimal decisions. The spellbindingly insightful observation that “human beings are not robots” took hold in the world of economics, and we saw an immense paradigm shift whereby we relinquished our deathly grip on antiquated ideas about human behaviour and replaced it with the infinitely more rational assumption that “human beings are emotional”. Daniel Kahneman (one of the pioneers of behavioural economics) distils this sentiment with far more eloquence and brevity than I ever could: “
“We are not thinking machines that feel; rather, we are feeling machines that think.”
Behavioural economics incorporates insights from psychology and other social sciences to better understand how people actually make decisions, acknowledging that they are often influenced by cognitive biases, emotions, and social factors.
The fundamental insight driving this new field was both simple and profound: human beings are not robots. We are complex creatures, driven by emotions, biases, and often irrational thought processes.
Understanding the psychological underpinnings of our financial decisions isn't just an academic exercise—it's a crucial step towards making better choices with our money. Ignoring these factors is like trying to navigate a ship without considering the currents; you might occasionally end up where you want to go, but more often than not, you'll find yourself off course. One particularly treacherous current in the sea of financial decision-making is temporal discounting. This psychological phenomenon explains why we often choose smaller, immediate rewards over larger, future ones—like opting for a new gadget today instead of investing that money for retirement. It's a prime example of how our emotions and biases can lead us astray, even when we think we're making rational choices. By exploring concepts like temporal discounting, we can start to understand the hidden forces shaping our financial behaviour and develop strategies to counteract them.
In basic terms, temporal discounting, also known as time discounting or delay discounting, is our brain's tendency to place greater value on immediate rewards compared to future ones. It's the reason why that extra slice of cheesecake looks so tempting now, even though we know we're trying to shed a few pounds for beach season. It's also why so many of us struggle to save for retirement, despite knowing its critical importance.
The Stanford marshmallow experiment (which I’ve talked a lot about before, mainly because I think it is one of the most important psychological studies that relates to the idea of effective decision-making) vividly illustrates temporal discounting in action, demonstrating how even children struggle to resist the allure of immediate gratification in favour of greater future rewards.
In the area of finance, temporal discounting can be particularly pernicious. It's that demonic, derailing little voice in your head that whispers, "Why save for a rainy day when you can buy that shiny new gadget now. Indulge child…" It's the reason lottery winners often go broke, and why credit card debt continues to soar despite unconscionable interest rates.
Temporal discounting isn't some vanishingly rare character flaw or uncommon moral shortcoming, it's a natural phenomenon, hardwired into our brains through millions of years of evolution. In the uncertain world of our ancestors, immediate rewards often held more survival value than distant, uncertain ones. You don’t really want to put too much effort into planning for next year's harvest if there is a very real possibility that a sabre toothed tiger might make you its dinner tomorrow.
But this is 2024. I can’t remember the last time I saw or even thought about a marauding sabre tooth tiger, or any equivalent modern day predatory threat.
Consider Sarah, a 28-year-old marketing executive who's been eyeing the latest smartphone. It's sleek, it's powerful, and it's expensive — $1,000 to be exact. Sarah knows she should be putting that money towards her retirement fund or building up her emergency savings. Sarah subscribes to my substack, and her rational mind tells her that investing $1,000 now could grow to over $15,000 by the time she retires, assuming an average annual return of 8% over 35 years.
But that new phone is calling her name. It's tangible, it's exciting, and it's available right now. The potential $15,000 in her retirement fund feels abstract and far away. Who knows what could happen in 35 years, right?
So Sarah gives in to the siren song of immediate gratification. She buys the phone, charging it to her credit card with an 18% interest rate. She tells herself she'll pay it off quickly, but life happens. A year later, she's only managed to pay the minimum each month, and that $1,000 phone has now cost her over $1,200 with interest - and she's still not even close to done paying.
This is temporal discounting in action. Sarah chose the immediate reward of a new phone over the larger, but distant, reward of a more secure retirement. It's not that Sarah is financially illiterate or lacks willpower. She's simply human, wrestling with the same evolutionary programming that's been shaping our decision-making for millions of years.
One weapon that we all have in our arsenal is knowing thy enemy. In this case I am referring to understanding the cognitive biases that affect all of us.
The Long Game: Temporal Discounting and Financial Planning
So, if temporal discounting is so natural, why should you fight it? Well, dear reader, because we no longer live in a world where immediate rewards are always the best choice, especially when it comes to our finances.
Following on from the Sarah example, if I offered you $100 today or $150 a year from now, which would you choose? Many people would opt for the immediate $100, even though waiting would yield a 50% return – far better than any savings account or relatively safe investment you're likely to find.
This preference for smaller, immediate rewards over larger, delayed ones can wreak havoc on our long-term financial health. It's why people often:
Underfund their retirement accounts: The future seems so far away, and that new TV looks so good right now.
Carry high-interest credit card debt: The joy of immediate purchases outweighs the pain of future interest payments.
Fail to invest in their education or skills: The cost and effort seem immediate, while the benefits feel distant and uncertain.
Don't save for major purchases: Why set aside money for a future down payment when you can enjoy smaller luxuries now?
Neglect proper insurance coverage: The immediate cost of premiums feels more real than the potential future benefit.
The Upfront Cost Conundrum: Why We Shy Away from Big Investments
Typically, when we think about temporal discounting, we're focused on how we undervalue future rewards or costs compared to immediate ones. But with large upfront costs, we're dealing with an immediate "pain" that leads to future benefits. In this case, we're overvaluing the immediate pain and undervaluing the future gain.
Consider these real-world examples:
Gym Membership: Your local gym offers two options - a yearly membership for $500 upfront, or weekly payments of $12. Over a year, the weekly payments add up to $624. Logically, the yearly membership is a better deal, saving you $124. Yet many people opt for the weekly payments, deterred by the large upfront cost.
Car Insurance: Most car insurance companies offer a discount if you pay your six-month premium in full rather than in monthly installments. For example, paying $600 upfront might save you $50 compared to six monthly payments of $108.33. However, many drivers choose the monthly option, effectively paying more for the same coverage.
Bulk Buying: Buying in bulk often offers significant savings. A 5-pound bag of rice might cost $10, while a 1-pound bag costs $3. Buying the larger bag saves $5, but many shoppers opt for the smaller bag to avoid the higher upfront cost.
Software Subscription: Many software companies offer both monthly and annual subscription plans. The annual plan is almost always cheaper overall, but requires a larger upfront payment. For instance, a service might cost $10/month or $100/year. The yearly plan saves $20, but many users still opt for the monthly plan.
Energy Efficiency: Energy-efficient appliances often come with a higher price tag but lead to significant savings over time. A standard refrigerator might cost $500, while an energy-efficient model costs $800. However, the efficient model could save $100 per year in electricity costs, paying for itself in three years. Despite this, many consumers opt for the cheaper upfront option.
Solar Systems: Installing a home solar power system offers long-term savings but requires a significant upfront investment. A 5kW solar system might cost $15,000 upfront (probably less) but could save a household $1,500 annually on electricity costs. Over a 20-year period, this system could potentially save $30,000, doubling the initial investment. However, many homeowners opt to continue paying their regular electricity bills of $150-$200 per month, potentially spending $36,000-$48,000 over 20 years. Despite the clear long-term financial benefits, many consumers choose to avoid the large upfront cost, effectively paying more for their energy over time.
In each of these cases, the aversion to a larger upfront cost leads to higher overall spending. This is temporal discounting in action - we overvalue the present (keeping more money now) and undervalue the future (greater savings over time).
The Psychology Behind the ‘Madness’: Why We Make Poor Financial Choices
So, why do we fall into these traps? It's not because we're stupid or financially illiterate (‘illiterate’ sounds a bit too pejorative, but I’m certainly aware that some people are yet to be exposed to certain information, and I absolutely include myself at the front of that category). The root cause often lies in how our brains process information and make decisions. Consider some of the psychological factors at play:
Loss Aversion: We feel the pain of losses more acutely than the pleasure of gains. Parting with a large sum upfront feels like a loss, even if it leads to greater gains in the future.
Uncertainty: The future is inherently uncertain. We know we have $500 now, but we can't be 100% sure we'll have the money to pay $12 weekly for a year. This uncertainty makes the upfront option feel riskier.
Present Bias: We tend to give stronger weight to payoffs that are closer to the present time. The immediate benefit of keeping more money now often outweighs the abstract future benefit of savings.
Hyperbolic Discounting: Our discount rates are not constant over time. We might prefer $100 now over $120 in a month, but also prefer $120 in 12 months over $100 in 11 months, even though the time difference is the same.
Mental Accounting: We often categorize money differently based on where it comes from or how we plan to use it. This can lead to irrational decisions, like being willing to drive across town to save $5 on a $15 item, but not on a $125 item.
Optimism Bias: We tend to overestimate the likelihood of positive events and underestimate the likelihood of negative ones. This can lead us to undervalue insurance or emergency savings.
Choice Paralysis: When faced with complex financial decisions, we often become overwhelmed and either make no choice at all or choose the easiest option, which isn't always the best.
Breaking Free from the Temporal Trap: Strategies for Smarter Financial Thinking
So, how do we avoid the perilous pitfalls of temporal discounting? Here are some strategies to help you think more long-term and make better financial decisions:
Visualize Your Future Self: Research shows that people who feel more connected to their future selves make better long-term financial decisions. Try using age-progression apps to see what you might look like in 20 or 30 years, or write a letter to your future self.
Use Commitment Devices: These are ways to "lock in" your future behaviour. For example, automatically transferring a portion of your paycheck to savings or investments before you have a chance to spend it.
Frame Choices in Terms of Opportunity Cost: Instead of thinking "Do I want to buy this now?", ask yourself "What am I giving up in the future by spending this money now?"
Practice Mindfulness: Mindfulness meditation can help you become more aware of your impulses and make more deliberate choices.
Educate Yourself: Understanding concepts like compound interest and the time value of money can make future rewards feel more tangible and motivating.
Create Concrete Goals: Instead of a vague notion of "saving for the future," set specific goals like "save $20,000 for a house down payment in 3 years."
Reward Yourself for Long-Term Thinking: Set up a system of small, immediate rewards for actions that benefit your future self. For example, treat yourself to a movie night every time you hit a savings milestone.
Do the Math: When faced with payment options, take the time to calculate the total cost. Seeing the numbers in black and white (written on a page) can help overcome the psychological pull of smaller, more frequent payments.
Use Technology: Many apps and tools can help you visualize long-term savings, automate good financial habits, and make smarter spending decisions.
Sleep on It: For big financial decisions, give yourself a "cooling off" period. The distance can help you think more rationally about the long-term implications.
Remember, the goal isn't to completely eliminate temporal discounting – it's a part of who we are as humans. The key is to be aware of it and develop strategies to counteract it when it's not serving our best interests.
—
As the seasons turned and a year passed in Whispering Woods, Terrance and Harry reconvened at the ancient oak. The time had come to see the results of their choices.
Harry hopped excitedly to the spot where he'd left his acorns. As promised, his 10 acorns had multiplied tenfold. He now had 100 acorns! "Look, Terrance!" he exclaimed. "We're rich! We can build the most magnificent burrow in all the forest!"
Terrance smiled at his friend's excitement but felt a twinge of regret. His 50 acorns had remained just that - 50 acorns. While he'd made some modest improvements to his home over the year, he couldn't help but imagine what could have been if he'd invested in the time-bending acorn.
As they began to plan their new burrow, however, they encountered an unexpected problem. The cost of building materials had increased significantly over the past year due to a shortage caused by a beaver dam project upstream. The 100 acorns that had seemed like a fortune now wouldn't stretch nearly as far as they'd hoped.
Terrance, ever the pragmatist, proposed a solution. "Harry," he said, "what if we combine my 50 acorns with your 100? Together, we'll have 150 acorns. It's not the fortune we dreamed of, but it's enough to build a comfortable home for both of us."
Harry's ears drooped slightly, but he nodded in agreement. "You're right, Terrance. And who knows? Maybe we can find that time-bending acorn again and plan better for next year!"
As they set off to begin their construction project, Owl swooped down from a nearby branch. "Well, well," she hooted, "it seems you've both learned valuable lessons. Terrance, you've seen the power of long-term investment, even if you missed out this time. And Harry, you've learned that even a good investment doesn't guarantee everything will go as planned."
The tortoise and the hare looked at each other. "You're right, Owl," Terrance said. "I think we've both learned that the best approach might be somewhere in the middle - saving for the future while still enjoying the present."
Owl nodded approvingly. "Indeed. And remember, my friends, in the great forest of life, every financial decision is a seed planted. Choose wisely where you plant, nurture your seeds with care, and be patient. The mightiest oak is grown from the smallest acorn."
*N.B. while I appreciate that the value of money changes over time due to inflation ($100 today will have less buying power in 10 years), for the purposes of this newsletter I have treated this as effectively negligible. Given that the long-term rate of inflation in many countries sits at somewhere around 3%, $100 today would still be worth $97 a year from now about $94 in 2 years from now, and around $86 in 5 years from now.