Hyperbolic discounting and why humans are mis-coded for financial planning

From an evolutionary standpoint, humans are not coded for successful financial planning. Our genetic make-up is based on a time when our two biggest challenges were physical threats – being attacked by animals – and scarcity of resources.

To evolve as a species over millions of years, we developed two very important behavioural biases linked to these two risks: seeking negative signals as a warning of impending danger; and seeking instant gratification because food scarcity meant our opportunities to eat were limited and unpredictable.

However, our evolutionary responses have not kept up with the changes and challenges in our environment. The world today has evolved from a place of scarcity to one of abundance. Instead of having too little food, our challenge is having too much food. We are consuming too much, smoking too much, drinking too much, and not exercising enough – and it is killing us.

Research from the World Health Organisation shows that today, four decisions (physical inactivity, poor nutrition, smoking and alcohol abuse) lead to four illnesses (cancer, heart disease, lung disease and diabetes) that drive 60% of global mortality and 80% of the disease burden.

We have also moved from a world of physical threats, such as being eaten by a wild animal, to one of systemic threats. Our concerns today are around the breakdown of interconnected systems – the Constitution, climate change, education systems and human rights - threatening to leave us adrift.

These changes – abundance versus scarcity and systemic versus physical threats – have only happened over the past 100 000 years or so, through the cognitive, agricultural and industrial revolutions. Human genetics and instincts haven’t evolved at the same pace, creating a fundamental mismatch between the risks we face and our behavioural responses.

Seeking negative signals is detrimental to financial planning because it leads to a flawed view that things are in decline. This sense of declinism is universal and pervasive – the majority of people around the world tend to think that the world is becoming a worse place. This holds true even though many of those same people are beneficiaries of trends showing that the world is in fact a better place (poverty levels and childhood mortality have significantly decreased while GDP per capita and literacy have improved). Whether in developed or developing nations, and despite evidence to the contrary, people uniformly seek negative signals that convince them that the world is becoming worse, not better.

South Africa in particular has been consistently negatively framed – we perennially think that our country is about to fail. However, statistics show that in the last 20 years, dramatically more people have access to formal housing; the JSE is 10 times bigger; poverty has more than halved; and nominal GDP has gone up nearly six times.

The data shows that being negatively-framed means we miss opportunities where assets, business and investment opportunities tend to be underpriced.

Success today and particularly in financial planning relies on the ability to resist our natural urges to seek only negative signals. Being negative is a primitive instinct. A sophisticated response is seeking out the positive as well.

The second issue is one of hyperbolic discounting – the fact that we seek instant gratification. It’s deep in our coding and it’s particularly pernicious when it comes to financial planning. We are not genetically hardwired for a world where there is too much to consume. That is why Discovery has been built around the idea of incentivising people to make the right choices – because we know we are behaviourally predisposed to make poor health and financial planning choices.

When it comes to financial planning, we save too late despite the clear evidence that we need to save as soon as possible, and as much as possible.

Hyperbolic discounting is our preference to choose a smaller-sooner reward (instant gratification) over a larger-later reward.

To explain why people often don’t see the urgency of saving for retirement, we performed an analysis¹ using an example of a male on our Discovery Life book to illustrate by how much people discount later years because they are further away from the present.

In our example, a male at age 40 is expected to spend 42% of his life in retirement, bearing in mind that life expectancy is a dynamic indicator. At birth, males may have a life expectancy of 79 years, but once they reach age 65, they have survived the average of those 65 years, so their life expectancy is now 83 or 84. Few people realise this and the implications it has for saving for the future.

So for example, while at age 40, approximately 42% of one’s life will be in retirement, due to discounting the years that are further away from the present, the perception at age 40 is that retirement will only count for 16% of one’s life². The older we get, the more it starts to accelerate, which explains why retirement tends to creep up on us.

In our minds, we are discounting the importance and impact of future years because they are further away from the present – until those future years become the present.

We are facing a tapestry of complexities in solving for the retirement needs of people that will continually live longer.

The human condition, with its genetic and instinctual coding, makes financial planning very complex. The mismatch that we face between what we know must be done and what we are coded to do as humans is fatal without excellent financial advice.

We need to be guided to see the opportunities and seek positive signals to draw the right conclusions. We also need to transfer risk through products that provide rewards, incentives and boosts.

Against this backdrop, financial planning plays a much more critical role in today’s context than ever before.

^{1. Assumption: Male life expectancy based on Discovery Life data is used. Discount rate used for hyperbolic discounting is 6%.}