What it is and how it works
You may have never heard the term before, but you’re definitely familiar with hyperbolic discounting in your everyday life; we all do it. Hyperbolic discounting is basically the tendency most people have to choose a smaller reward that comes sooner, rather than a larger reward that comes later. The term was coined by psychologist Richard Herrnstein and has been used to explain phenomena as varied as people’s investment choices, personal finance decisions, procrastination, addiction, lapses in willpower, and more.
Every time you delay for tomorrow something you could do today, choose the dessert instead of the mint tea, or charge something to your credit card, you’re likely falling victim to this behavioural bias. Indeed, it’s mercilessly taken advantage of in marketing to get you to part with your cash. For example, the idea of “buy now, pay later” is an advertising strategy that specifically targets your tendency to discount hyperbolically. You get the product or service now, but don’t have to worry about the money until later.
In classical economics, it’s almost taken for granted that the rate at which people discount future rewards is fixed. In other words, the further away from the present movement you move, the more likely you are to wait for the larger reward. This is called exponential discounting. The problem with this is that it doesn’t seem to match people’s actual choices, which seem to follow a hyperbolic curve rather than an exponential one. People discount future rewards at a far greater rate when the time they have the least time to wait for the smaller reward. In plain English, they will prefer to take $100 today rather than $110 next month, but will choose $110 in six months rather than $100 in five months. Strange, right? It’s the same exact choice, except in the second example it’s projected 5-6 months out.
These behaviours, also known as “time-inconsistent preferences,” cause people to make irrational, short-term decisions that they may regret in the long-term, and to exhibit self-control issues when the consequences of those issues are separated in time. To think about it in another way, if smokers could really feel the adverse impact of every cigarette they smoke, many of them would choose differently. Or if a person with certain fitness goals could immediately see the impact of every piece of junk food they eat, then they too would possibly be more likely to opt for the healthier option.
The reason it’s so hard to be disciplined in the moment is that the consequences of bad choices are often incremental and distributed over time. The effect of a weekend of heavy drinking and binge eating will not show up on your hips the very next day. Similarly, smokers are causing very incremental damage to themselves that only manifests itself as illness many years in the future. Also, people who find it difficult to save don’t ever get to see what a boon it can be to have a lump sum in the future just by saving a few inconsequential pennies here and there in the present.
Without wanting to delve too much into armchair evolutionary psychology, you can understand why privileging short-term gains over long-term ones may have been a good evolutionary strategy in the past. For most of human history, we have lived from hand to mouth, our next meal never guaranteed, and in such an environment, you can see why weighting the present over the future may have been a good idea. It may also be why, even to this day, the sure thing right now has such an irresistible allure for us, as well as where sayings like, “a bird in hand is worth two in the bush” originate from.
Hyperbolic discounting and trading
Behavioural biases like hyperbolic discounting reveal themselves to traders in many ways. The most obvious of which is the way that most traders have been repeatedly shown to cut their profits and let their losses run rather than doing the opposite. The old trading wisdom goes that you should cut your losses and let your profits run. In other words, it’s considered prudent to close losing positions quickly, and to keep winning positions open for longer in the hope that they may perform even better as time goes on. This obviously requires a very different mindset that’s not vulnerable to hyperbolic discounting.
If you’ve been trading for any length of time, you’ll be very familiar with this dilemma. It’s often difficult to resist closing a position that’s in profit. Naturally, the urge is to lock the profit in right now, as a sure thing, rather than holding onto the position for longer and risking that it goes the other way. In a similar vein, it can be psychologically painful to close a losing position, realising the loss right away, rather than to hold on to it for a bit longer in the hope that it will turn profitable in the future and thus help you to avoid taking a loss. Daniel Kahneman and Amos Tversky’s Prospect Theory has repeatedly demonstrated that humans are willing to risk more to avoid a loss rather than to make a gain (another cognitive bias that probably has an evolutionary history).
And it’s this second, less obvious example of loss avoidance that’s most interesting, as there’s a rather counter-intuitive implication that you should be aware of. Veteran traders often say that if you don’t close a losing position in good time, you’re turning a trade into an investment. In other words, you’re forcing yourself to hold onto an asset for much longer, in the hope that it will go back up, when to begin with all you were engaged in is a short-term trade. What’s fascinating about this scenario is that according to the logic of hyperbolic discounting (you’re willing to wait longer for a pay-off the further it is into the future), you could be holding on to losers, waiting for them to pay off in the future while not appreciating the risks of doing so.
A losing position in the present, as we’ve shown above, is difficult to close, unlike a winning position. So, effectively, a losing position in the present becomes a potential winner in the future, causing you to be more willing to wait the further that potential win is projected out. However, it’s important to realise that sometimes you could be holding on to a real stinker that will eat at your account balance over time, while not appreciating the risks involved because you’ve become so accustomed to the wait. Remember, trading isn’t saving, holding onto a loser into the future is no more of a guarantee that it will go up in a year from now than it will in a day. It can sometimes feel that way, and that’s a huge blind spot you need to be aware of. It’s important to be aware of how vulnerable you are to these biases so that, armed with knowledge of them, you can hopefully avoid taking certain things for granted that can lead to costly mistakes.