Discounting

William Forbes Wiley (2009)

Behavioral Finance - Chapter 3

The divided self

y The next step is to break open the black box called the individual and

similarly realise because of self-control problems that lead to nonfunctional behaviour the individual cannot be said to maximise in the simple sense we economists have assumed for the last two hundred years (Jensen 1998) pp. 48 .

Behavioral Finance - Chapter 3

Book of Common Prayer

We have left undone those things that ought to have done; and have done those things we ought not to have done, and there is no health in us. based on St Paul Romans 7 Even prior to Christian thought the Greeks spoke of a disorder called akrasia or weakness of will. The popularity of self-help books, Christmas savings clubs, weight watchers, Alcoholics Anonymous suggests the game has not changed in recent times.
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Examples
I explore how this is being done by various behavioural finance theorists in the context y of self-control (dieting, saving, addiction), Benabou, R. and J. Tirole (2002). "Self-confidence and personal motivation." Quarterly Journal of Economics 117(3): 871-913. y Discounting cash-flows Laibson, D. (1997). "Golden eggs and hyperbolic discounting." Quarterly Journal of Economics 112(May): 443-477.

Behavioral Finance - Chapter 3

Illustration
Consider two choices A) Receive 1 apple today Receive 2 apples tomorrow. B) Receive 1 apple in 1 years time, Receive 2 apples in 1 year and a days time.
Behavioral Finance - Chapter 3

How did you do?

Most people choose 1 in Choice A, but 2 in Choice B. They have a much higher discount rate when considering outcomes in the near future compared to choices involving distant outcomes. To some degree this is simply because the future, like the past, is another country.

Behavioral Finance - Chapter 3

Lesson
y We seems to make time-inconsistent choices, seeking almost instant

gratification now, but not anticipating the impatience we feel within ourselves in a years time. Hyperbolic discounting tries to capture this timeinconsistency in our .

Behavioral Finance - Chapter 3

Exponential versus sequential discounting

We apply exponential discounting to cash-flows almost without thought or discussion. So we apply a discount factor of the form (1-r)T Where T is the number of periods hence in which the cash arrives. Hyperbolic discounting implies a discount rate of the form

1 (1  T )
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Laibsons quasi-hyperbolic discounters

y Laibson (1997) suggests a slightly different form of same sort of

hyperbolic discount factor

1 if T ! 0, i.e. Now H ! F (1  r )T  T " 1i.e. Then

Where 0< < 1 reflects the initial impatience of the investor with a

quasi hyperbolic discount factor.

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The fate of hyperbolic discounters in the market

If Mr Exponential encounters Mr Hyperbolic in the market during summer he can offer to buy his winter coat off him, offering him the same value as he attaches to that coat himself. In winter he can the sell it back to him at a predictable profit. Nice work if you can get it.

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Behavioral Finance - Chapter 3

In Praise of folly
You may ask how can such foolish behaviour endure in an evolutionary process favouring those most able to acquire resources. y Hyperbolic discounting may favour impulsive, but socially useful behaviour, conception of children, marriage, participation in the political process, y Maybe future planning was not a high priority until the industrial age and the rise of widespread participation in financial markets.
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The self as a population

If different incarnations within ourselves vie for satisfaction and decision-making autonomy we need to model equilibrium strategies adopted by individuals and which incarnation of that individual makes them prior to modelling how those individuals trade in markets.

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Behavioral Finance - Chapter 3