Behavioural experiments have shown that when given an option to have $100 now, or $120 a year from now, most people choose the more immediate reward of $100 now. As David Brancaccio of the NY Times puts it:
“Most people pick immediate gratification, even though the smart choice is more money later. After all, what other investment is going to yield a guaranteed 20% return?”
This tendency is a cognitive bias called hyperbolic discounting, where people prefer to have a reward they can have now, rather than a reward that they’ll have to wait for. Because our brains prioritize behaviours that make us feel rewarded as soon as possible, future rewards lose value, even if they are more valuable than immediate rewards.
In personal finance, the immediate rewards we’re talking about is the joy from spending now, while the later rewards are the returns on investment we’d like to get for the future, for example, retirement. Hyperbolic discounting can make it difficult for us to choose delayed rewards over immediate ones because we don’t always see that the money we have now can grow if invested. For example, according to a Wells Fargo survey, a third of working Americans close to retirement age (55-59) choose to save for their retirement later instead of saving now. Even more troubling, according to a Gallup Report, 1 in 5 Americans tapped into their 401(k) retirement savings prematurely. These statistics are alarming, considering the consequences they can have.
Consequences of choosing immediate rewards over delayed rewards
Accumulating unnecessary debt
You have been borrowing money for your wedding this summer, but come across a great new coat that you can’t resist charging to your credit card. When you take on unnecessary debt that you can’t pay off immediately, your debt keeps increasing due to compound interest.
Losing time to grow your wealth for the future
You got a bonus. You think you need a vacation to relieve stress. Why bother saving for retirement so soon, when you can enjoy your life right now? If you start saving from an early age, your money can grow much more significantly with the magic of compound interest. These savings can later on be invested or kept for your retirement in the future.
Ways to choose delayed rewards to grow wealth
Consider opportunity cost
When choosing immediate reward, consider how much return you might get in the future if you choose delayed reward. For example, calculate a potential return on investment you might get in 5 years for a $500 purchase you want now.
Set your future financial goals with a timeline
Having specific monetary goals with a deadline will motivate you, and help curb immediate spending by prioritizing those goals. Use S.M.A.R.T. financial goals to come up with your own goal list.
Pay for your future first (automate savings)
Set regular automatic transfers to your long-term investment (e.g. high interest savings account, retirement plans, investment vehicles). Allocate a percentage of your income for your future before you have a chance to spend it.
Do NOT make bigger purchases with the credit card crutch.
Plan and save money for bigger purchases, so if you do use a credit card, you won’t accumulate interest (regular credit card interest is over 19.99%. If you have a $5,000 debt, your annual interest is almost $1,000, and it will keep compounding)
Give yourself small rewards for sticking to your financial plan.
Hyperbolic discounting happens because we prioritize wanting to feel rewarded. If you can reward yourself for staying on track, you’ll be more motivated to do so in the future. For example, treat yourself (to something reasonable) when you achieve your monthly savings target.
Mission possible
If you think it’s too challenging to delay reward, scientists have proved it is possible. The Stanford marshmallow experiment has shown that children (and even adults) are able to delay an immediate reward for a more valuable later reward. Even more interesting is that, when they do, they receive greater pleasure from that reward and even tend to have greater life outcomes overall than their peers.
Choosing delayed rewards to grow wealth is challenging when our brains naturally prefer immediate rewards. However, you can rest assured that Pinkfolio’s features, including calculation tools to show the advantage of growing your wealth now, will motivate you to choose delayed rewards over immediate ones.