"The impact of hyperbolic discounting on investment decision-making"
In today's fast-paced world, where instant gratification rules the roost, it's easy to become dazzled by social media platforms like Tik Tok and Instagram and the convenience of same-day delivery, but have you ever considered the long-term effects on our cognitive abilities and social interconnection?
If your answer was yes, then I am sure you have come across the Marshmallow Test, a psychological experiment conducted in the late 1960s by Stanford psychologist Walter Mischel to study delayed gratification in children and its effects on their development. If your answer was no, attempt to divert your urge to click on the many tabs open on your browser and join me in asking the fundamental question: what is the impact of hyperbolic discounting on investment decision-making?
Mr. Walter Mischel rightly points out in the video that willpower has been a difficulty for humans since the days of Adam and Eve, who yielded to the serpent's notorious apple and lost paradise in the process.
The experiment's findings revealed that youngsters who could defer gratification and wait for two marshmallows fared better in areas such as academic success and social competence in the long run. Therefore, if I were a betting man, I'd wager everything on the youngster in the grey shirt in the video above. Let us hope he will be an asset manager or capital allocator one day!
As a participant in the financial markets, it is critical to be aware of the possible dangers that might result from our own cognitive biases. One such bias in relation to the Marshmallow Test is hyperbolic discounting, which occurs when we place a higher value on rewards that are closer in time than gains that are further in the future.
This bias can lead to “suboptimal decisions”, such as choosing a smaller immediate reward over a larger delayed reward. You do not have to look too far, the investment world is riddled with quantitative measures that focus on volatility per month/day or risk adjusted return per quarter/year. It is important to note that this bias can not only affect individual investors and institutional investors, but also the management teams of publicly traded companies.
One example of a publicly traded company where the management team may have exhibited hyperbolic discounting the now infamous Enron case. Enron's management team made a series of decisions in the late 1990s and early 2000s that prioritized short-term gains over long-term sustainability.
Some of these suboptimal decisions include, but are not limited to :
Complex off-balance-sheet special purpose companies (SPEs) were formed to conceal debt and losses.
Mark-to-market accounting was used to exaggerate earnings and conceal losses.
Overstated revenue and earnings by employing aggressive revenue recognition techniques.
manipulated energy prices in California during the 2000-2001 energy crisis
Executives were paid significant sums while the company's financial state was concealed.
Enron's leaders served as directors of the SPEs that the corporation used to hide debt and losses, resulting in conflicts of interest.
Employees who sought to voice concerns about the company's operations were intimidated and threatened.
WeWork is a more recent example in the corporate world, where the management team focused on quick expansion and short-term profits above long-term financial viability, ultimately leading to the company's near-collapse in 2019 and the withdrawal of its initial public offering (IPO) plans.
So, how can we avoid falling into the trap of hyperbolic discounting? One technique is to use planning and implementation intentions, which help to increase the perceived value of future rewards and make it more likely that we will choose to wait for the larger reward. Another technique is to break down the larger reward into smaller, more manageable steps, making it more tangible and less abstract.
One technique suggested by Warren Buffet when it comes to investing is the "inner scorecard" method of measuring success, rather than relying on external validation. Individuals and businesses may use inner scorecards to focus on their objectives and ideals, resulting in increased self-awareness, personal progress, and overall satisfaction. He has on many occasions also argued that there is very little value from quarterly earnings guidance from publicly traded companies. He feels that its tends to promote an unhealthy focus on short-term profits at the expense of long-term performance.
As market participants, it's essential to be aware of our own cognitive biases, such as hyperbolic discounting, and take steps to mitigate their impact on our decision-making. By being mindful of the potential pitfalls and taking a long-term perspective, we can make more informed and financially sound investment decisions.
If we are successful we can finally get our hands on the two marshmallows at the end of the experiment. Hmm what a treat!