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Mental accounting and temporal discounting

We assume that there is someone there who is indifferent between $48 now and $50 in six months, someone that wold indeed seem pretty patient in isolation, this person is willing to wait six months just to gain two dollars. But let’s think about this not as a one-shot decision but as a potential investment.

Context and temporal discounting

This decision is equivalent to an investment with an effective rate of return of about 8,5% per year roughly similar to the average annual return for the broad stock market over the past 50 years and unlike the stock market this decision is risk-free. Let’s consider another example.

If you report that you would rather have $100 now than $110 in one month, then you are turning down a risk-free investment with 185% annual return. No I can’t guarantee much of my investing advice but I can guarantee this: that’s far better than any risk-free investment that you or I will ever be offered.

Behavioral economists have argued that people engage in a sort of mental accounting for the financial decisions. They assigned decisions to different mental accounts and applied different rules to each account. So the same person who has some of her retirement savings locked in the long-term treasury bonds that return 2% per year can come in the laboratory and turn on a guaranteed return of almost 200% per year.

The retirement savings and the money earned in the laboratory reflect two different mental accounts. Now it would be much more efficient for us to apply the same rules across all such accounts, so that we are too impulsive in one setting into patient and another, but that turns out to be very difficult, at least without the sort of tools all provided in this article.

Why we discount

So far I described what temporal discounting is but let’s now move to the question of why we discount. There are at least three explanations for why rewards are worth less in the future and they are in the present.

1. First, delayed outcomes can also be risky outcomes. We’ve already talked about the idea of a risk premium we provide a higher expected return when we invest in something risky, like the stock market, then we obtain will be invest in something safe like a money market account waiting to receive her award also carries risks.

The promise of a future reward might not be kept, our personal circumstances might change, we might step in front of a bus tomorrow or he might win the lottery. The longer the delay the greater the risk and thus the less a future award should be worth.
Explaining temporal discounting in terms of risk makes intuitive sense, but it doesn’t explain everything.

As one piece of evidence against this explanation people’s attitudes toward risk and attitudes toward delay or only weakly correlated. Someone who is very risk-averse might also be very patient in their temporal decisions even though being patient should carry more risk.

Likewise when people are faced with large decisions say those involving thousands of dollars they become more risk-averse, but also more patient so we can’t explain away the temple discounting is just a natural response to risk.

2. A second explanation is more psychological temporal discounting arises from temptation. I mentioned that people tend to discount primary rewards like food and juice much more rapidly than money. Moreover people who find a particular type of reward especially tempting like those people who report loving candy chocolate or chips show faster discounting for that reward than for other similar rewards.

An addict shows very very rapid discounting for drug-related rewards. They value drugs when they can be obtained right now and they quickly discount the value for future drugs to almost nothing. That temptation also plays a role in temporal discounting seems intuitive.

We’ve all felt the lure of some tempting reward like a piece of cake and it’s easy to see how the temptation can cause us to overvalue the present at the expense of the future, but it can’t explain all aspects of temporal discounting. Temptation doesn’t explain why we show such high discounting for money, especially when we don’t desperately need that money right now.

And even after controlling for the relative temptation associated with different sorts of rewards statistical analyses revealed that there still something left over, a more general sort of impulsiveness or patience that extends across all of our decisions.This means that temptation at least by itself can’t explain temporal discount.

3. There is a third explanation though and it’s a bit more subtle than the other two. Think of a 25-year-old say a single male in the United States who is just beginning to save for retirement.

Every dollar saved for retirement is taken away from his 25-year-old self that money is not available for dinners out with friends for buying running shoes for purchasing books to read or for what ever other activities he values right now.

Instead it is set aside for the as yet unknown desires of the 65-year-old self. Perhaps the 65-year-old self will like to travel or will want to support charitable causes or will need long-term medical care. He doesn’t know and cannot know what is 65-year-old self will use the money for, he just knows that it is a good idea to reserve some of his current money for that future self.

I emphasize this third perspective because it can guide us toward specific steps that can help us resist temptation, become more patient and, yes, even save more for retirement.