We described how investment types think about compounding and discounting in the related videos on this and related topics. Essentially, the idea was that we operate symmetrically in terms of going forwards and backwards in time. And that the rates that we apply when we travel are constant for each year forward and backward. Sometimes, this thinking does not align with how individuals actually process time and we even refer to this in the video. Many, like myself call it mental time travel, and it can give rise to inconsistent time choices. Others call it hyperbolic discounting, but we don’t really want to know what that means!!!
Think ice-cream. Given a choice of one scoop of ice-cream today or two scoops one-week from today, many of us might choose today rather than wait the extra week. (Of course, that also depends on whether it is after or before dinner, how big a meal you plan to eat or have eaten, but that complicates still further, so let us leave it out for now). It is a simple choice, we have mentioned it before as “smaller-sooner” being preferred to larger later. I know we don’t think of discounting and compounding explicitly when it comes to things like food and ice-cream, but it is only a way to figure out how we make choices. In boring finance terms, the discount rate we apply to bring next-week’s two-scoops back to today is much larger, so we value it less and therefore choose to eat one-scoop today!
But imagine that the same choice was given to you further out into the future. One-scoop in 52 weeks or two scoops in 53 weeks? We are more likely to say, if I have to wait a year, what is one more week, so we may choose to wait one extra week, one year from now, when we were not willing to wait that extra week right now? The one-week discount rate applied to that ice-cream, 53 weeks later (to bring it back to 52) is much lower than the one-week discount rate we applied to one-scoop one-week from now, wouldn’t it be? How much we discount seems to be depend on how far we are discounting from.
Economists like to call this inconsistent behavior. But to me it also means that there are dimensions to our behavior that are not well understood and are therefore also difficult to model. Just be aware that our personal preferences for short-term versus long-term investments, and how we approach those decisions is much more complex than the simply rules of thumb that financial advisors are always thrusting at you!