All of us have goals in our life, and a majority of them are linked to having adequate finances available at the time that the goal date arrives. Be it your Child’s education, your comfortable retirement or the purchase of an asset, proper Financial Planning begins with mapping out goals clearly and then defining a “plan of action” to achieve these goals.
Every year, thousands start off planning for their financial goals with serious determination and good intentions. Yet, only a fraction of them eventually go on to achieve their goals! This mainly due to a psychological phenomenon called “Hyperbolic Discounting” which is the No. 1 enemy of your financial goals (and must be vanquished if you are to achieve them!)
The Magnetizing Power of “NOW”!Given a choice between receiving Rs 100,000 in 12 months or Rs 110,000 in 13 months (both guaranteed), what would you choose? 90 per cent of the attendees at a recent corporate workshop we conducted chose the 2nd option – a logical choice, given the assurance of an extra 10% return in just a month!
Now what about the choice between receiving Rs 100,000 immediately (in cash, across the table) or Rs 110,000 after a month? (both guaranteed). Surprisingly, the same set of attendees now leaned towards the 1st option - although the payoff is precisely the same in both scenarios (wait 30 days/ receive Rs 10,000 extra)!
What prompted people to act irrationally in the 2nd scenario? You guessed it – “Hyberbolic Discounting”!
What is Hyperbolic Discounting?Research in the field of Human Psychology has shown that our brains attach low significance to important rewards that are still a long distance away. Not just that – the farther away the goal, exponentially lower the significance we attach to it – even if it’s actually a very important goal! (For instance, retirement for a 30 year old)
Basically, your mind tricks you into believing that buying a brand new car or an iPhone today is more important than saving for your child’s college tuition (a reward that will be realized 10-15 years later) - although all of us will acknowledge that the latter is a far more important life goal! That’s Hyperbolic Discounting playing its tricks.
We get magnetized by the “NOW” factor and take irrational decisions – such as liquidating our retirement fund to buy a gadget, dipping into our child education fund for the down payment of a house, and so on. Instant gratification is indeed a powerful driving force!
Beating The Curve…The question is - how do we defeat Hyperbolic Discounting and march on successfully towards the completion of our goals? While there’s no easy solution (since your personal willpower will play a major role!), we offer two rather simple but effective pieces of advice in this regard:
1. Know Your Priorities (KYP)Don’t go about dealing with your Financial Goals aimlessly! Mapping your important long and short term financial objectives is a very fruitful exercise. Having a clearly written roadmap in front of you will help you work past your mind’s innate tendency to fall for “Hyperbolic Discounting”. Map out your goals clearly in terms of current amount, inflated amount, goal date, etc. A qualified Financial Planner can help you with this.
2. Systematically Save At Least 25% Of Your Monthly IncomeHaving mapped your goals clearly, start maintaining a balance between your lifestyle and your savings by putting your goal based savings on autopilot. Save 1/4th of your monthly income for your goals before you spend (like an EMI!). If your income goes up, work out the new savings amount based on the 25% rule and increase your “auto-savings amount” in proportion.
A Word of Caution…Over the years, we’ve observed numerous financial plans falling apart due to Hyperbolic Discounting. People start off with retirement fund targets of Rs. 5 crore and then end up liquidating them for more “instant” payoffs by the time they save up 50 lakh, without realizing just how much damage they are causing.
Awareness is the first step! The next time you feel tempted to utilise your long term savings for more “pressing” immediate needs, pause for a moment and ask yourself – is it really worth it?