Feb 15

Holding Periods and Hyperbolic Discounting

Investment and patience have never gone together. We might assure ourselves we are investing for the long term but all too often our emotions get in the way. A growing fascination with tracking the daily ups and down of the stock market can make investors sell too quickly or trade too much.

Behind this preference for fast gratification lies an investing bias known as hyperbolic discounting. It means that we show a marked preference for current consumption over future rewards. Hyperbolic discounting helps to explain the challenge of getting us to invest for far-off retirements. As rewards are delayed further into the future, we assign them less value.

Studies, for example, show that most people would take $100 today over $200 in two years time, but would not take $100 in six years over $200 in eight years. Rationally, there is no reason for this – we should find these trade-offs identical in relative terms.

The problem is the way that we think about time is not rational. As points in time are pushed into the future, we come to view them as simply faraway points on a fuzzy horizon. This treatment of time seriously complicates how we attach value to future rewards. The value of savings to a man aged 65 are obvious but, without a time machine, showing this to the same man in his twenties is a problem if he assigns little value to a distant reward. The issue then is that valuable years of compound investment growth can be lost to inertia.

Binding Commitments

One of the main methods of addressing this human failing is via making commitments; ideally, binding commitments. In the same way that people find it easier to train for a marathon once they have made a commitment to raise money for the effort, commitments can be useful in investing.

Superannuation is a great example of a binding commitment. It effectively bars people from using their savings before retirement and it benefits from favourable tax treatment to further promote saving over consumption.

There is no such binding commitment for a managed fund or holdings of shares. Given the patience required for investing, this poses a behavioural challenge to investors at a time when holding periods of shares have fallen to historic lows.

There is plenty of evidence to show that investing in a well-chosen portfolio of high-quality shares has been a winning strategy over time. But time is a critical part of the process. It follows then that self-control is a critical part of investing. For some investors, it might be better not to monitor the daily fluctuations in markets if these merely cause them to question the value of holding investments.

Source: Fidelity (October 2012)

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