“Our favorite holding period is forever.”

—Warren Buffet in Letter to Berkshire Hathaway Shareholders, 1988

How many people actually complete their New Year’s resolutions? It shouldn’t be difficult, but year after year, whether it is to maintain their ideal weight, save adequately for retirement, or otherwise accept short-term pain for a long-term benefit, very few people can stick to the plan. They simply cannot defer gratification. The difficulty people have in delaying pleasure is a result of time discounting.¹

Time discounting describes the tendency to give in to immediate gratification urges—going for small short-term gains in the present while sacrificing larger future rewards as a consequence. What is fascinating about time discounting is that people intellectually know they will experience bad consequences from current misbehavior later, but at the moment of temptation their limbic gratification-seeking self overrides this warning while the prefrontal cortex looks on helplessly.

The normal brain’s discounting function has been defined by a series of economics experiments. In the prototypical experiment, when asked if they would prefer $10 now to $11 in a week, most people choose the immediate $10. If asked whether they would prefer $10 a year from now or $11 a year and a week from now, most people choose the $11 in a year and a week. If they chose the $11 in a year and a week, and a year passed, and they were offered the opportunity to change their decision, a majority would now go for the $10 today. This pattern suggests that many people practice hyperbolic-like discounting, with a disproportionate preference for immediate and imminent rewards.² In general, people are more impatient when making decisions about smaller shorter-term gains versus longer-term larger ones.

In general, the average person prefers $100 now to $140 delivered in one year, implying a “discount rate” for immediate rewards of 40 percent,³ much higher than an average stock market return. The only rational reason they would want the $100 now is if they can expect to make a larger annual return than 40 percent with the money, which is very doubtful.

When the potential monetary rewards are displaced in time so that subjects are choosing between $100 in one year and a larger sum thereafter (e.g., two years), the “long-term discount rate” is typically measured to be around 4.3 percent,⁴ which is slightly less than short-term interest rates would dictate.

The pursuit of immediate gains can lead investors to abandon stable long-term investment plans. Mutual fund purchases (when investors flock into last year’s best performers), short-term trading decisions (especially in a long-term investor), and retirement savings decisions are all often biased by time discounting. Many investors pursuing short-term gains are more inclined to pay premiums over fair values. Those investors who get a “hot” stock tip may rush to buy, even borrowing on margin, to catch an anticipated share price jump. In the options market, short-term thinking (time discounting) leads to options premiums out of line with mathematical models.

Discounting also occurs for potential punishments, though this chapter is primarily about gains. Most people avoid small, immediate punishments if they can choose to wait for larger, later ones.⁵ Procrastination (putting off unwanted duties until later) is an effect of such punishment discounting. In Chapter 9, we saw a counterpoint to procrastination in which “high dreaders” will accept a large electric shock immediately rather than wait (and suffer the anticipation) of a smaller one. The effect in which dread inspires higher cost avoidance is due to the immediacy of the punishments on offer. The experiments that test the “dread” effect don’t require waits longer than five minutes. Even procrastinators will get down to work and accept the pain when the pressure grows too intense as their deadline nears.

Not everyone is subject to the same discounting tendencies. For the most part, people fall on a spectrum, from highly discounting (drug addicts) to gratification delaying (the most disciplined savers). Furthermore, certain conditions predispose people to become more or less discounting. Cues that a desired goal is near provoke discounting. Time pressure incites discounting. People who are self-controlled, such as those who are high in the personality trait of conscientiousness (self-disciplined, organized, and rule following), exhibit less discounting than those who are more impulsive. Among substance abusers, researchers have found that their personal discounting curves are correlated with both their degree of impulsiveness and their addiction severity.⁶

GET YOUR HAND OUT OF THE COOKIE JAR

When I was a psychiatry resident, we watched an educational film about self-control experiments with children. In the movie, four- and five-year-old children were brought into a room and seated at a desk. A cookie was placed on the desk, and the experimenter said something to the effect of, “This is your cookie. You can eat it whenever you want. I’m going to step out of the room for a few minutes. If you haven’t eaten the cookie when I get back, then I’ll give you a second cookie and you can eat both of them.” The researcher would leave the room for a few minutes. The kids would sit at the desk and think about their predicament.

Some of the kids would immediately gobble up their cookie. When the researcher returned and didn’t give them a second one, they complained, “That’s not fair!” Some kids simply leaned back in their chairs and calmly waited, deferring their gratification until they could double up. Some kids wanted to wait, but, almost as if by no intention of their own, their hands would creep across the desk toward the cookie. One kid was really tormented—he ended up sitting on his hands, bouncing up and down, and practically squealing in agony until the researcher returned.

The study tracked these kids for 10 years. A child’s ability to wait for the second cookie was a pretty accurate prediction of later academic success and SAT scores. Ten years later, parents of the two-cookie hold-outs rated their children as more attentive, better able to concentrate, more goal oriented, and more intelligent than the parents of the one-cookie gluttons. The two-cookie parents also viewed their children as more able to resist temptation, tolerate frustration, and cope with stress.

How the cookies were presented also affected performance. When the cookies were hidden from sight, children could wait longer. When they were asked to think about the taste of the cookie, the children waited less. If they were asked to think about objective aspects of the cookie—such as shape and color—the children were able to calm their desire and delay longer. The authors found that self-control, modulated by thinking, begins between ages 9 and 12, and they concluded that the ability to delay gratification is an important, and overlooked, type of intelligence.⁷

A follow-up study in 2006 reported that children who were able to turn their attention away from the cookie (implying better cognitive control over attention and focus) can better delay gratification. The ability of these children to intentionally shift their attention away from temptations may be the key to their success later in life. The researchers speculate that because attention relies on frontal cortex connections with the “striatum” (which contains the nucleus accumbens), the ability to defer gratification may be an “early marker of individual differences in the functional integrity of this circuitry [impulse inhibition circuits].”⁸

BRAIN BASIS OF DELAYED GRATIFICATION

Instant gratification is the preferred choice of the reward system, while exercising self-control and long-term planning is the function of the brain’s prefrontal cortex. Samuel McClure, a neuroscientist at Princeton University, performed a brain-imaging experiment with volunteers engaged in a time discounting task. Subjects were given several decision pairs, between which they were asked to state their preference. For example, they could choose between either an Amazon.com gift certificate worth $20.28 today or one worth $23.32 in one month. In a longer-term example, they asked subjects to, for example, choose between $30 in two weeks and $40 in six weeks.

McClure found that time discounting results from the combined influence of two neural systems. Limbic regions drive choices in favor of immediately available rewards. The frontal and parietal cortices are recruited for all choices. These two systems are separately implicated in emotional and cognitive brain processes, and there appears to be a competition between the two systems during discounting-type decisions, with higher limbic activation indicating a greater likelihood that immediate gratification will be pursued.

In particular, McClure found that when experimental subjects choose larger delayed rewards, cortical areas such as the lateral and prefrontal cortex showed activity enhancement.⁹ These brain regions are associated with higher-level cognitive functions including planning and numerical calculation. McClure’s theory is supported by a finding that in prisoners the cortical regions activated by delayed gratification are thinned. This may explain why their decisions are more often short-sighted than others.¹⁰ According to McClure, “Our results help to explain why many factors other than temporal proximity, such as the sight or smell or touch of a desired object, are associated with impulsive behavior.”¹¹ If impatient behavior is driven by limbic activation, it follows that any factor that produces such activation may have effects similar to that of immediacy. ¹² According to McClure, immediacy in time may be only one of many factors that, by producing limbic activation, engenders impatience ¹³ and impulsive action.

The implications of discounting extend far beyond financial decisions. “‘This can explain why we engage in all manner of self-defeating behaviour,’ Professor Laibson said. ‘The emotion centre says stopping smoking today will be very painful, but agrees it would be OK in a week. A week later, it says, ‘I know I agreed a week ago, but I still want to postpone it.’”¹⁴

The ability to exercise self-restraint is essential for accumulating capital—according to some studies, those who exercise more self-control are, on average, wealthier. Any positively arousing aspect of an investment, such as an association with opportunity, success, or imminent gain, may cause similar limbic activations to those found during time discounting. Emotion shifts decision making to limbic circuits and weakens one’s ability to delay gratification. However, strong prefrontal cortex activity can inhibit the limbic urges to chase immediate gratification.

CHEMICAL IMPULSES

On the chemical level, opiate chemicals (such as morphine) induce time discounting, leading to greater impulsive choice. For example, heroin addicts temporally discount money more steeply when they are in a drug-craving state (immediately before receiving an opioid agonist, such as heroin) than when they are not in a drug-craving state (immediately after using heroin).¹⁵ The addict’s impatience for a “hit” also prompts greater impatience (discounting) in other areas of reward processing.

Medications that reduce the frequency of impulsive choices include opioid receptor blockers, which inhibit the release of dopamine in the reward pathways. Attenuated dopamine decreases the pleasure of immediate gratification. Successful treatment of impulse-control disorders such as pathological gambling and kleptomania (addiction to stealing) is seen with opiate receptor blockers such as naltrexone ¹⁶ and nalmefene.

MONKEY BUSINESS

Evolutionarily, discounting may make some sense for the survival of our species. Steep discounting may have been highly adaptive when most (if not all) valuable resources were perishable or were difficult to defend given the lack of defined or enforced property rights.¹⁷ Supporting this theory is the finding that our primate cousins, both monkeys and apes, have great difficulty delaying gratification.

For example, in a type of experimental game called a reverse-contingency task, the experimenter delivers a large reward whenever the subject reaches for a smaller treat and delivers a small reward whenever the subject reaches for the larger treat. When playing this game, monkeys and apes do not learn to reach for the small reward (in order to get a larger meal). When the task is modified so that they are reaching towards a symbol of a smaller reward or larger reward, most primates catch on. It may be that the sight of the actual reward ignites their limbic circuits, undermining the inhibitory function of the prefrontal cortex.¹⁸

Professor Dan Ariely at Massachusetts Institute of Technology (MIT) designed a functional magnetic resonance imaging (fMRI) study in which subjects were asked to choose between receiving money in one month or viewing an alluring pornographic photograph immediately. Participants had to respond continuously, by pressing a button, in order to avoid seeing the photograph and receive the money. Ariely made the experiment challenging by scaling the payments for avoiding the photo. When he offered small rewards for bypassing a high-quality image, more people chose to view the photo than to receive the (small) payout. Ariely found that charging higher prices makes self-control easier. The brain regions that activated when subjects declined the pornography and chose the one month later payout were in the—you guessed it—prefrontal cortex (inhibition) and also in the parietal cortex (a brain area associated with calculation of expected returns).¹⁹

In the modern world, technologies such as the Internet, bank account fees, credit cards, and retirement savings plans have vastly increased the personal financial costs of time discounting and impulsiveness. The remarkable array of desirable and immediately available consumer products, coupled with clever advertising schemes that appeal to basic impulses and desires, may be important contributors to the persistent failure of people to save adequately for their own retirement.²⁰

MAKING A KILLING IN THE OPTIONS PIT

In the markets, time discounting is most dramatic during investor panics. The immediate short-term gain being sought is relief from painful declining positions. According to Richard Friesen, a retired options specialist and former seat holder on the Pacific Stock Exchange, during periods of market volatility, emotional responses can become the major driver of risk perceptions and option values. At these times, investors may be more preoccupied with licking recent wounds than taking risk. As a result of the immediacy engendered by unforeseen crises, out-of-the-money options, particularly puts, gain large premiums. This would seem to be the best time for option writers and premium sellers to exploit investors’ increased risk perceptions, but sometimes the market’s fear is contagious.

Ideally professional options traders are conditioned to maintain equanimity during periods that others perceive as dangerous crises. They should be able to maintain a long-term perspective even when others see the world with steep, fear-induced, discounting curves. According to Friesen, during market crises “we couldn’t sell option premium fast enough.”

As Friesen tells it, in the midst of the October 1987 stock market crash, he and his options trading colleagues were stunned by the irrational option values. The trick was to avoid going into shock while the entire financial system appeared to be heading towards a cliff.

On that October Monday, the trading pits were eerily tense, loaded with bids to buy puts, but with none of the floor traders willing to step in and sell them. Friesen recalls that one of his colleagues walked forward into the inaction of the trading pit and offered to sell options for an enormous premium. Panicked investors and brokers under orders to forcibly liquidate bankrupt accounts snapped up his puts. His selling price guaranteed that he would make money unless the stock market dropped by another 50 percent. Soon his firm was doing the rational behavior of selling puts to emotional buyers. According to Friesen, “Trading at times like these is magic. You are standing on rational grounds and trading with a crowd in emotional panic. It is like an ‘out of the body experience.’ You know exactly what is going to happen, and can watch the prices collapse as trader after trader sees the truth you already knew.”

IMPROVING SELF-CONTROL

“We don’t get paid for activity, just for being right. As to how long we’ll wait, we’ll wait indefinitely.”

—Warren Buffett at 1998 Berkshire Hathaway Annual Meeting

Researchers have found that the best way to enforce self-control and reduce procrastination is to have an external rule enforcer, such as a colleague or spouse, who can set meaningful punishments and rewards for adhering to the plan.²¹

Another behavioral strategy for reinforcing self-control is avoidance. If a dieter walks by a tempting donut shop every morning on the way to work, he might shift his path to avoid the donut shop, thus bypassing the cues that normally trigger irresistible cravings—the smells and sights of sweet, warm donuts. Similarly, if an investor finds that she tends to panic out of long-term positions when she checks quotes and sees the price declining, she can either avoid the information source or enter protective stops.

Professor Terry Burnham, co-author of Mean Genes, reports in the book that he enjoyed day trading so much in the late 1990s that it interfered with his social life. One year, he made a quarter billion dollars in transactions. He realized that he needed to use external measures to help him slow his trading, and he tried several techniques. He used a dial-up instead of a broadband connection to the Internet, he closed his discount brokerage account (requiring him to call a human broker to place trades), and he occasionally had friends hold on to his Internet cable during the evenings so he would not check the markets after hours. External behavioral enforcers, such as those used by Burnham, are some of the most effective self-control fail-safes.

Much of the art of self-control is cognitive—using different thoughts, feelings, and memories to convince oneself of the value of restraint—while other techniques are behavioral. For example, an ex-smoker may pine after “just one” cigarette but then call to mind the deceased grandfather whose emphysema devastated his vitality. The association of cigarettes with the suffering of a family member might evoke strong disgust and a reflexive urge to avoid smoking.

Practitioners of neurolinguistic programming, such as motivational speaker Anthony Robbins, locate the emotional origin of one’s desire to continue a noxious habit. Then mental exercises are used to reverse one’s emotional association from good to extremely negative. For example, if one is unable to follow a diet plan because of a propensity to sneak bites of dessert, then one should locate the fond memory or association driving the craving.

One may have childhood memories of being brought desserts by her grandmother when lying ill from the flu. To reverse this loving and positive association with dessert, one can call to mind all the negative and damaging aspects of desserts. Repeatedly feel the emotional intensity of the following images and associate them with desserts. For example, bring to mind that heart disease runs in the family, having killed one’s uncle, and recall that dessert will cause that effect in other loved ones. Picture the bulging atherosclerotic plaques on their arteries (find photos on the Internet if you need a reference). Imagine how the sugar is accelerating your aging process and weakening your immune system, predisposing you to colds and chronic illness. These are only examples.

For yourself, consider a habit you’d like to break, find appropriate reversed associations, and feel them. Then repeatedly feel how toxic that habit is until the very thought of it makes you extremely uncomfortable. For example, investors might want to break a habit of falling in love with stocks (the endowment effect). Such investors should take extra effort to find negative information or opinions about the company. When feeling amorous, they can consciously recall how badly they felt when other stocks they loved let them down (and damaged their bank account).

IN PRACTICE

According to the Wall Street Journal, the best biotech analyst of 2005 was Martin Auster, MD.²² When I asked Auster what differentiated him from other analysts, he indicated that he takes a longer-term view of the stocks he covers. While most analysts look at upcoming clinical trials and products over the next 6 to 12 months, Auster looks ahead 12 to 18 months. This longer-term perspective ensures that he is well positioned when other analysts turn their attention to events he had already priced into his recommendations.

Investors can enhance self-control and combat time discounting by identifying where they are vulnerable. For most investors, discounting drives short-term thinking when they are feeling emotional (such as in volatile markets). For example, a professed “long-term” investor may inappropriately buy a stock due to excitement about an upcoming product release or earnings announcement.

There are many advantages to understanding time discounting that depend on one’s specific needs. Professional analysts can benefit from looking out further than their competition. Options traders can take advantage of investors during panic, when they see only immediate danger and want immediate protection from further losses, at almost any price. Portfolio managers can remember to avoid being swayed by short-term earnings anomalies. Interestingly, investors occasionally engage in discounting collectively, leading to conformity in perceptions and herding behavior in the markets.