By: Dan Erdle

There are two things you can do with your money: 1) allocate it to things you want in the present or 2) allocate it to things you are going to want in the future. The choice is between getting a reward today or getting a potentially larger reward at a future date. This is the choice between consumption and investment.

 

Consumption VS. Investment

Some level of current consumption is just mandatory. We all need to satisfy certain basic needs but beyond meeting our basic needs we are left with an important decision: we can enjoy things today at the cost of having less in the future, or we can build up our future enjoyment at the cost of having less today.

Think of this as having to place your money in one of two buckets.

In your consumption bucket are the resources you spend on things in the here and now. What things in the consumption bucket have in common is that they serve to reward you today, they are non productive meaning they don’t produce cash for you, and they are depreciating assets. Some consumption assets depreciate incredibly quickly. Any money you spend on meals this month depreciates to 0 the moment you eat it. Same thing with clothes—they lose their value incredibly quickly. Every time you drive your car you are losing money. The TV you buy today is for sure going to be worth less in the future. Even though consumption assets depreciate, most often to 0, what they do give us is current gratification.

In your investment bucket are appreciating assets. These are productive assets in that they generate cash for their owners. Stocks are the equity ownership in a business which sell goods or services in exchange for cash. Bonds receive ongoing interest payments creating income into the future. Real Estate generates rental income for its owners. The investment bucket requires us to delay gratification so that we can build up greater rewards for the future.

Successful people try to limit the money they allocate to the consumption while trying to get the maximum amount they can to the investment bucket. Looking at the big picture, some portion of your money will be in depreciating assets and some will be in appreciating assets. Successful people try to divert as much as they can from the consumption bucket and instead load up the investment bucket.

 

Our Brains Favor Current Consumption

In talking about allocating to the consumption bucket or the investment bucket I made it sound like everything was on neutral footing and all we had to do was rationally allocate resources to one or the other and that most times we would favor the investment bucket. That was a lie. Sorry.

The truth is that we are up against a major disadvantage because we are not starting from a blank slate but instead must deal with pre-programmed mental wiring from millions of years of evolution as a species. Our mental processes are not there to find the objectively rational position—they are inherently biased in that the signals our brain produces favors those that were useful over evolutionary history. Here there is no question: the unconstrained and undirected workings of the brain favor current consumption.

This result shouldn’t be shocking in that for the entire history of life on this planet resources have been scarce, life has been short, and getting your genes to the next generation was the challenge. Therefore, evolution favored animals that brought their gratification forward in time. An animal that in the present moment ate a lot, bred a lot, and looked out for its current security did incredibly well.

As a result of our evolutionary past, resisting the temptation of present gratification is difficult because the brain’s reward systems are heavily biased towards the present: it takes full account of immediate rewards, but heavily discounts rewards that are delayed. Thus, choosing an immediate gain gives you a jolt of dopamine that you cannot get from choosing a delayed reward.

In tests monitoring the activity of our brain as we anticipate receiving a near term reward we see the reward centers of the brain in places such as the nucleus accumbens and the sensory thalamus fire to signal the rest of the brain that a reward may be coming. Then a sustained, escalating response ensues as neurons keep firing until the reward is delivered.

But here comes the real dark side of present gratification. The feeling of satisfaction from receiving a present reward, the one we have been doing all of this for, well it fades incredibly quickly. There is no sustained feeling from near term gratification. This was because in evolutionary history if an animal became content for too long after meeting its needs it would be eaten, fail to mate, etc. Evolution did not favor a bunch of satisfied animals sitting around basking in the glory of their recent accomplishments. Once one desire was met, gratification fades quickly and its on to the next desire that must be met.

We all probably notice this with the things that we buy. Before we buy it we think it is going to be this amazing thing and that once we have it we will receive constant enjoyment. But think about all of the things you have bought that are now just commonplace in your life even though you were really excited to buy that thing. It turns out that the anticipation of getting something is actually larger than the enjoyment you get when you actually have it.

So the brain is wired up to do three awful things to us:

1. Favor near term rewards at the expense of long term ones
2. It builds up in our mind how great something is going to be once we have it
3. Once we do attain it, the reward is cut off and we start all over

Trying to find an objective point of view, the problem with current consumption is that once we get our hit of enjoyment it is used up. Because we have used those resources on current gratification we have necessarily drawn against the resources devoted for our future happiness. This was fine in evolutionary history when life was short, who cared if you only lived in the moment. But this may not be an optimal strategy for modern times.

Think of us as all having a “happiness bank” to draw from over our lifetimes. If we withdraw happiness now, not only do we use it up now so that we can’t in the future, but by using it now we eliminate the possibility it could have grown with time. Life is a series of choices of when to draw rewards from our happiness bank and when to build them up for the future. Some people choose to favor their present happiness others delay gratification in hopes of larger future rewards.

Successful people in modern times tend to have their eye to the future much more than their present situation. It also means successful people can delay gratification—they have the ability to pass up reaping rewards today and instead bank it for the future. This is what we mean by investment. We are giving something up today in hopes that as a result we will receive a greater payoff in the future.

Notice though that investment is not without its cost. And it’s a big cost that most people have a hard time overcoming because it goes against the hard-wired circuitry of our brains. The cost is that we must sacrifice present consumption.

Our brains want us to consume today but there are long term benefits from delaying gratification. We will naturally favor the short term to the long term, but that doesn’t mean that now that we know the internal biases of our mental circuitry that we can’t act deliberately to overcome them. It just might be more difficult than we would like, but people can do it.

 

The Marshmallow Test

The marshmallow test is a famous psychological experiment designed to test children’s ability to delay gratification. A researcher sits down with the child at a table and the researcher places something sweet in front of the child like a marshmallow. The researcher then explains that the child can either eat the marshmallow right now, or if he or she can wait, the child will get two marshmallows.

The researcher tells the child that they are going to leave the room for ten minutes and when the researcher comes back into the room, if the child has not eaten the marshmallow, the child will get the second marshmallow.

The researcher leaves the room. For many kids once the researcher is out of sight that marshmallow is gone. The kid immediately downs the marshmallow without giving it much thought. But a few kids take a little bit more time to think about it.

You can witness these kids doing everything they can to try to withstand the impulse to eat the marshmallow. But clearly the natural thing to do is to eat the marshmallow, and it is taking conscious effort to resist doing so.

Notice the difficulty here. The child is being asked to trade an actual tangible marshmallow for two hypothetical future marshmallows. What’s happening is the child’s higher-level thinking systems such as the prefrontal cortex is locked in a tug of war with the lower level more primordial motivational systems that govern things such as hunger.

The hypothalamus is shouting, “you fool, see that delicious marshmallow right there that tastes so good, grab it quick and stuff it down before something bad happens and its gone.” And its not that obvious on first impression that the hypothalamus is wrong. It does have a point. In fact we know that it must have a point if it has survived millions of years of evolutionary history; it must be useful or it would not have been selected for.

Yet we can see that there may be situations where the brute force of the hypothalamus might be wrong. And one of those situations might be one illustrated by the marshmallow test: a situation where there might be an even bigger payoff than the one in front of you if you can just delay gratification into the future. The hypothalamus seems to lack the nuance to tell the difference. It seems to always assume the correct answer is to consume right now. This is probably because something analogous to the marshmallow test came up very rarely in the state of nature.

But notice how situations like the marshmallow test may come up a lot more in an advanced economy like our modern society. The hypothalamus was incredibly useful during times of human history when the satisfaction of basic needs was really all there was. But the hypothalamus is probably not the most useful guide for modern problems like portfolio management or business decision making. The problem is that our lower level biological systems like the hypothalamus don’t know when they are not needed.

The really interesting part of the marshmallow test is that the researchers continued to follow the kids as they progressed through life. What the researchers found was that the kids who were able to delay gratification by holding out for the two marshmallows had much better outcomes later in life. The kids who could delay gratification ended up scoring better on the SAT, they reported higher levels of self-confidence, they had better social skills, showed greater ability to plan, handle stress, and concentrate in the face of distractions. The ability to delay gratification pays off in modern life even if it didn’t for our primate ancestors.

 

How to Catch a Monkey

If you want to catch a monkey what you will do is take a tall narrow necked jar and place some treats such as a banana or cookies inside of it. A monkey will come by, smell the treats, and he will realize he can put his hand in the jar and grab the cookies.

This is the beginning of trouble for the monkey.

Once the monkey has his fist clinched around the treats he won’t be able to get his hand back out through the narrow neck of the jar. All he would have to do is unclench his fist, letting go of the cookie, and bring his empty hand back up the jar the same way he was able to put it in.

But to get his hand out, the monkey would have to relinquish something he already has. A monkey is simply unable to do this. Monkeys are unable to conceive of the fact that the solution to a problem could be sacrificing something so concrete and good as that present cookie.

A monkey catcher can just stroll up to the monkey, pick it up and carry the monkey off with his hand still stuck in the jar. A monkey’s undoing can literally be caused by him getting his hand caught in the cookie jar.

This is not the fault of the monkey. A monkey is a victim of pure unregulated signals from his hypothalamus which 99% of the time produces good outcomes for the monkey. It just doesn’t work in novel situations where the solution to the problem is taking a hit in the present moment in order to place yourself in better future situation. The hypothalamus cannot tell the animal not to listen to its hypothalamus.

The animal will not sacrifice the part for the whole. Humans armed with a prefrontal cortex and a much more developed neocortex have the cognitive ability to imagine a hypothetical future state being made better by current sacrifice. It just took us a long time to put this ability in to action.

 

When Humans Learned to Bargain with the Future

For much of human history things were pretty much always the same. If you lived 10,000 years ago it really wasn’t all that much different than if you lived 5,000 years ago and that wasn’t much different than if you lived in 1200 AD. Humans came and went, but nothing fundamentally changed in terms of day to day human existence.

Life was short and the time spent on Earth was mainly spent desperately trying to satisfy our most basic needs. One of the major problems was that people believed that future wasn’t really going to be much better than the present. If things had pretty much been the same for the past thousand years, why would the future during my life be any better? There was little incentive to delay gratification and invest for the future. In fact, for much of human history the concept of investment didn’t really exist.

Even if you did have an original creative idea, what was the incentive to personally forego your current happiness to try to put it into action. The honest assessment was even if you could come up with something wonderful you would likely not be able to enjoy the payoff. You could easily die next week from a wild animal, or you catch a terrible disease, or the king could arbitrarily order you to war. What if you started a business and one of your customers decided to simply take your product and never pay you. What are you really going to do about it?

What if you had a great idea but no current resources. Who is going to invest or loan you money? From a lenders perspective we have the exact same problem just discussed. The truth is the lender is likely not going to get paid back, or the lender could die before getting paid back, or even if the lender does get paid back there is nothing stopping someone from simply robbing him once he becomes better off. Therefore, if you had resources it made little rational sense to loan it to someone else when you could instead focus on your own current happiness. For thousands of years even if you could get someone to loan you money, when you got a loan it was small, short term, and at high interest rates.

Humans were locked in a vicious cycle in which no one wanted to make any investment because the future was so bleak and unreliable, and one of the primary reasons it was so bleak and unreliable was because no one ever made any attempt to forego present gratification to make the future better.

All of these things began to slowly change beginning only around 500 years ago. A bunch interconnected historical forces came together that gave rise to many of modern ideas we all currently hold. At this time came the Scientific Revolution, the Enlightenment, and the beginnings of free market capitalism. Along with these three interconnected major revolutions of human thought and behavior came individual liberties, protection of private property, an independent legal system, and greater political participation for the masses. Since then the world has continued to get better and better.

 

With these changes humans were able to overcome one of the major obstacles holding us back—we were finally put into an environment where delaying gratification in the present would finally pay off in the future. We learned we could bargain with the future. We could deliberately not consume today in order to consume more in the future. People could finally make investments.

In the year 1500 global production of goods and services was equal to about $250 billion; today it is around $60 trillion. Annual per capita production in 1500 was $550, while today every person on the globe produces around $8,800 per year. For the past 500 years human progress has accelerated at a rapid rate driven by people’s trust that the future would be better than the present. The ability to bargain with the future unlocked a huge amount of human potential that had been squandered for thousands of years. Today humans continue to reap the benefits of delayed gratification by investing for the future.

 

Discounting the Future

What has been implicit so far but maybe hasn’t been explicitly stated is that in order to delay gratification, we must be properly compensated. The reward for delaying gratification must be both large enough and certain enough to compensate us for giving up a sure thing in the present. For thousands of years future benefits didn’t offer the necessary compensation, so humans simply didn’t make present investments.

Think about the following proposition:

I can give you $100 right now or you can wait a year and I will give you $105. People may be split on what they would do but my guess would be many people would favor the current money. They would quickly be trying to do some intuitive calculation concerning whether an extra $5 is worth having to wait an extra year.

If instead I offered $100 today or $1,000 a year from now, I feel like almost everyone would choose to hold out for the year. I think most people would feel more than compensated for their time by the additional reward.

Notice the internal mechanics of your thought process as you try to figure out what to do in these situations. What we are doing in our mind is an attempt to make some kind of an adjustment across time to figure out whether the future reward is large enough for the time we have to wait to get it. In our minds it is likely to be rather imprecise but we all do approximately the same thing. In finance and economics we call this discounting the future.

Discounting the future is the attempt to make adjustments across time to try to put payoffs on roughly equal terms so we can compare them. I would take $100 today, but if I had to wait 5 years I might demand $200. What has happened is that I have discounted the future to say that $200 in five years is approximately equal to $100 today. We are trying to account for the fact that if we have to wait to receive some benefit we should get some kind of bonus for doing so. The longer we have to wait for something the bigger the bonus should be.

In finance rather than using this process as a rough approximation we try to become more explicit about what we are doing. Take the first proposition I gave you: $100 today or $105 a year from now.

Rather than make an intuitive guess about what to do, what is the rational way to solve the problem? It revolves around what rate of return you think you could get on your money if you took the $100 today. Lets say you took the $100 today and could get 8% on your money. A year from now under the first option you would have $108 compared to $105 if you would have taken the second option. Therefore, you are better off a year from now taking the $100 today and investing it at 8% than you would under the second option that only offered $105.

Things would change however if you could only get 3% on your money. In that case a year from now you would only have $103 compared to the $105 being offered by the second option.

In finance we use the intuitive method all people seem to have in which we make adjustments across time to see if a future benefit compares favorably with a present one. Except in finance we call this adjustment across time discounting the future and we use explicit rates of return which we call discount rates to try to figure out with future rewards are worth what we have to give up in the present.

In the above example we only had to do this across one year. When we are buying something like a stock we are doing this exact same process but we are doing it across a time scale for as long as we think the business could be around. This could be 50 years, 100 years, or perhaps even forever. But regardless of the timescale we use, the mindset is the same: we are trying to figure our whether the future rewards justify giving up a sum of money in the present.

If I buy a stock today for $50, the per share cash flows produced by the business in the future better produce more than $50 because I have to wait well in to the future to receive them. Since I am giving up $50 of consumption today, I must receive the appropriate compensation to make it worthwhile. We would buy the stock if we thought the future cash flows of the business, adjusted for the fact that we must wait to receive them, were greater than $50. We weigh the future cash flows generated by the business against its current price to see if the rewards are adequate.

If the future benefits are adequate, postponing consumption (delaying gratification) can provide us with greater overall rewards during the course of our life. The human mind may tilt us toward present consumption, but delayed gratification is the best solution when future rewards are greater than current costs.

 

Takeaways

• We have a choice between present consumption and investment (delayed gratification).
• Successful people divert a greater proportion of their resources to their investment bucket because these are appreciating assets rather than depreciating.
• Our minds are not a level playing field—we are hard wired to prefer current consumption.
• Current consumption is likely not to yield the level of enjoyment your mind builds it up to have; evolution made gratification fade quickly so we keep wanting more.
• The marshmallow test illustrates that delayed gratification is possible and that numerous benefits accrue to those who defer rewards in the future.
• Humans, while influenced by our primate ancestors, have the cognitive ability to consider alternative versions of the future; we can sacrifice the present for a better future
• For thousands of years humans were locked in a negative cycle because future rewards were not adequate to get people to give up current gratification.
• Investment is all about weighing future rewards against what we have to give up in the present.
• We should make investments (delay consumption, delay gratification) when the future rewards are greater than current costs adjusted for the time we have to wait.