A new paper explores ‘present bias’ in financial decisions, the tendency to prefer immediate comfort over future benefit.Ziga Plahutar/iStockPhoto / Getty Images
If you’ve ever wondered what the cost of procrastination is, one economist has an answer: it’s like a perpetual 14-per-cent consumption tax. It would effectively be the same as doubling or tripling the amount of sales tax Canadians pay, depending on which province they live in.
Mind you, that’s an extreme scenario based on a paper just published in The Quarterly Journal of Economics that looks at someone who has the highest degree of “present bias” and is oblivious to it. In plain English, that would be someone who procrastinates all the time (and may not be aware of it because they keep on doing it.)
Present bias is essentially the tendency to prefer immediate comfort over future benefit. Trade-off decisions generally have two components: the negative emotion of giving something up and the positive emotion of receiving something. If you want to save for retirement and have more money down the road (feels good), you have to trade that off by foregoing consumption today in order to set aside money (feels bad) to invest.
But what seems like a good choice on paper is distorted by present bias. The magnitudes of emotions are warped based on how close to the present they are. Whether good or bad, if it happens today it would feel really good or really bad. If the emotion is to be felt 40 years into the future, it barely registers.
But the paper’s author looks at the financial world and challenges the idea that suboptimal outcomes are primarily a willpower issue. He suggests that the financial landscape of products make it too easy for people to undo the behavioural safeguarding strategies needed to overcome their procrastination. Put another way, we need strategies to force our present selves to behave in ways our future selves will thank us for.
For example, putting money into an RRSP for retirement has a “liquidity” penalty in the form of taxes, which would have to be paid immediately if the funds were withdrawn. The desire to avoid doing so serves as a barrier for many from raiding their RRSPs for preretirement consumption.
Similarly, many people like the idea of buying a home because the mortgage payments are a form of forced savings. They may run the math and find the home-price-to-rent ratio in some cities means it makes more sense to rent and invest the savings. But in the end, they opt to buy because they know they wouldn’t actually save and invest the difference.
The problem is there are a lot of ways the financial system can tempt you away from self-imposed discipline. Like access to lots of credit on cards that charge double-digit interest rates, buy-now-pay-later (BNPL) services that allow you to pay in several installments with no or low interest, and the dopamine hit of trading crypto or even just straight-up gambling.
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The paper’s model suggests that behaviour becomes more impulsive when we have low personal liquidity. If we tie up too much money in accounts or strategies that lock us down in some way, access to any other dollar is more likely to be used frivolously. (As our financial stability increases, this effect dissipates.)
When you take a big-picture look at borrowing money, we are effectively accessing future income and paying a price to do it. There are many useful uses for this, such as buying a home or paying for an education to increase our lifetime earning potential. But frivolous borrowing is very much against the welfare of our future selves.
So perhaps the lesson from this research is not that we just lack discipline. It’s that the discipline we manufacture by using strategies that are hard to unwind (tax on RRSP withdrawals, higher interest rate for locked-in GICs, forced savings through a mortgage) can too easily be undone by the ease of borrowing against our future income through other parts of the complex financial world we live in. And that’s another reason why it feels so hard to truly get ahead. It’s not that we don’t know better. It’s that the financial environment makes the worse choice far too easy.
Preet Banerjee is a consultant to the wealth management industry with a focus on commercial applications of behavioural finance research.