Original Cin

There’s an interesting post on Marginal Revolution regarding personal discount rates. I’ve actually been thinking about this for a while. A lot of what I’ve read on personal finance just doesn’t include the concept.

I tried looking around Wikipedia for an overview of the philosophy of discount rates, but couldn’t find one. The closest thing there is the article on time preference:

In economics, time preference (or “discounting”) pertains to how large a premium a consumer will place on enjoyment nearer in time over more remote enjoyment.

There is no absolute distinction that separates “high” and “low” time preference, only comparisons with others either individually or in aggregate. Someone with a high time preference is focussed substantially on their well-being in the present and the immediate future compared to the average, while someone with low time preference places more emphasis than average on their well-being in the further future.

This is a bit difficult to digest, to put it mildly. The basic idea is simply that $1.00 today is worth more than $1.00 a year from now. Because you have to pass “a year from now” in order to get to “fifty years from now,” $1.00 at the end of fifty years is worth even less than $1.00 at the end of a year.

Having a discount rate of 0 has some unusual and bizarre consequences (I vaugely remember some of the funnier examples from college). Suppose you knew that you were going to live for exactly another 40 years, had a consistent personal discount rate of 0, and were completely unconcerned with the state of the world after your death. If someone were to offer you $0.01 of interest to borrow all of your money for 39 years, 364 days, you should accept this offer, because you’d have more money at a greater (present) value than if you didn’t! Likewise, if helping a friend had any value to you at all, then you should be okay with lending $1000 interest-free to them for the same period of time, since it would still be worth $1000 to you in the future! Who wants to live like that? Even in an environment free from physical risk, a discount rate of 0 makes no sense.

Yet, a lot of personal financial advice seems to assume a discount rate of 0. Consider various examples (see About.com, the SEC) extolling people to cut back on their daily cup of coffee because of the amount that money could grow into. Yes, if you can cut “just” $1.00 a day in your expenses, and place the money at the end of the year into stocks getting a return of 10% for 40 years, you’ll have approx $16,519. But, take into consideration a discount rate of 3% and the $16,519 in forty years is worth just $5,064!

Now, turning $365 into $5,064 is still impressive. Very impressive. But it’s a far cry from turning $365 into $16,519 (a 1287% return versus a 4425% return). And don’t forget that you have foregone something that presumably had a present value of at least $365 to begin with! 3% is probably too low a discount rate, IMHO.

It’s very easy to turn down the mental abstraction of a cup of coffee. What’s more difficult to grasp in discussions like this is what that actually means on a day to day basis — how a cup of coffee may be part of a routine that involves talking with friends, or sitting around and thinking about life. Even more disturbing is how such examples miss the forest for the trees — some financial writers have pointed out that starting with bigger expenses in your budget just makes more sense! If you can cut $100 a month by living in a smaller home, then the $30 a month from a daily coffee is no longer so impressive, or so important. If spending $5 dollars a day sends a signal to others that boosts your productivity and/or earnings by a greater amount, then do it. I believe in living frugally, but I also believe in having fun in the here and now.