Present value: The worth of something today, at this moment.
Future value: What it will be worth in the future, at some fixed point of time.
It’s basic finance.
A hundred bucks today. That’s the present value.
If I assume I can earn 10% on it – what I would call opportunity cost – in a year it’ll be 110, in two years 121, and so on.
The future value at year 1 is 110, at year 2 is 121. The present value today is 100.
These are exactly the same statements here – we’re assuming you can’t do better than 10%, and you don’t need the money in hand urgently.
So I’m saying the same thing when I say I have a hundred bucks today or a 121 in two years.
In other words, the Net Present Value (NPV) of 121 bucks in two years is the same as 100 today.
If you spent hundred bucks today and got 121 after two years, you’d end up with 0 NPV.
You get that by bringing the value of 121 from two years in the future to the present, i.e. dividing it by the interest rate it would have compounded by in these two years.
NPV = (121/1.12)- 100 = 0
The same idea applies outside finance, to everything else.
But it’s hard to see it the same way, because “a bird in hand is better than two in the bush”.
It’s sort of like a recency bias – we tend to give more weight to the immediate, to the now.
Orders of Consequences
Every action (and inaction – which is just the action of not doing something) has consequences.
Anything you do almost never exists in isolation; it triggers a chain of actions and consequences.
I’m stick to reasonable consequences, things that aren’t farfetched to imagine, that have a non-miniscule probability of occurring.
If you eat a dozen burgers a day – getting obese would be a reasonable consequence.
Eating a burger and dying because it was poisoned? I wouldn’t call it reasonable, unless you really anticipate being poisoned every meal you eat – in which case you’d probably have an army of food tasters.
First order consequences – are immediate, directly related to the action, and easily foreseeable.
So getting momentary pleasure after binging on junk food everyday is a first order consequence. Or feeling sick because of it.
It’s like present value. What you have today.
Second order consequences – they’re downstream results of an action.
They’re also usually foreseeable – though people like to pretend they’re not, because it’s easier to evade responsibility for your actions leading you to them that way.
After a while, if you maintain that diet, you’ll be putting on weight.
That’s a future value at a shorter date.
Third order consequences: These are even more indirectly linked to the action than second order consequences, and thus harder to predict.
You probably wouldn’t even have intended them.
They might take a long while to take effect and you might not even become aware of them for a long time after they do.
Maybe someone who gives into his craving every day becomes weak-willed over time, unable to resist any temptation.
And maybe the person who doesn’t overeat stays in good shape and over time develops an iron will.
Obviously, this is just a simplistic scenario, only meant to show that there are different orders of consequences for what we do.
It doesn’t imply that all fat people are weak-willed or stupid.
Lots of people don’t care that much about their weight; there are other things they care about more. There’s nothing wrong with that.
Delayed Gratification
Gratification is pleasure, and delaying it is supposed to separate the poor from the rich, the fit from the unhealthy, the hardworking from the lazy, the ambitious from the stagnant.
It’s easy to see why.
Someone who fulfils every urge to stuff himself with junk food probably won’t be in great shape.
Someone who spends all his money as soon as he gets it probably won’t be rich.
Someone who spends his life chasing highs and drugs probably won’t be a person with a stable job.
Someone who lazes around all day probably won’t achieve as much as someone who’s up and about.
Delayed gratification is what almost every one who’s reading this practices to some extent.
Studying to go to a good college or get a good job or working long hours to make money to spend later – everything is about doing penance today to enjoy tomorrow.
It’s not that there’s something wrong about gratification; on the contrary delaying it is a strategy to maximize it.
You might want to loaf about. And you might hate to work.
But you don’t need to be a genius to see that the future value of going to a good college or getting a good job is probably more than the present value of loafing about.
Again – it’s not going to be true for everyone. Some people genuinely wouldn’t care about money and maybe they’ve thought about it and realized they’d prefer loafing around over working hard.
You could come to 4 different types of people based on how they respond:
- They know that they want to be richer, and they’re able to delay gratification.
- They want to earn well but they don’t want to work for it.
- They don’t really care about being well off and would prefer to loaf around, but they go along with what they think they should be doing.
- They loaf around because they don’t really want to work for more money; they don’t need more than what they have.
The first guy realizes he has a positive net present value – the positive value of being rich in a distant future more than makes up for the negative value of working today.
He’ll bake his cake and have it gladly.
The second guy wants to have his cake but doesn’t want to bake it. He’ll probably regret it, and might pretend like he doesn’t care, but almost definitely will envy the first guy when he has what he himself wants.
The third guy bakes his cake but doesn’t really want to have it.
The last guy doesn’t bake his cake because he doesn’t want one. He sees there’s no point making an investment in something with a negative NPV.
Most people make these calculations all the time, even if they don’t realize explicitly they’re doing that.
Networking is often just this – someone who might be useful later, meaning someone with a potentially high future value – is sought today, in the present.
Future Value
Where does future value come from?
I think it comes from second, and even more so, third order consequences.
People realize the first order consequences – the direct, immediate consequences of their actions might be painful, but one day it’ll be worth it, because of the second and third order consequences.
So even after you bring the future value to the present, like we divided 121 by 1.12, it still carries more weight – just replace 121 by 150 and you’ll have a positive NPV.
Rationality
Most disciplines usually assume humans are “completely rational”.
In economics, that often means people maximize their utility – give them a hundred bucks, and they’ll spend it to get the biggest bang for their buck.
I think that’s a pretty good way to look at rationality – people act in ways they think are the best for them; they act in what they think is their best interest, whether it be a soldier, a saint or a robber.
If I go back to the example above, about 4 types of people – the second and third maybe aren’t acting rationally.
They know they want something but they don’t act on it; they act against it. The second guy wants to be rich but doesn’t want to put effort to achieve it, and the third puts effort to achieve something he doesn’t seem to value.
Obviously, there’s a “maybe” here – maybe the second guy likes the idea of being rich, but likes lazing around even more – so he’s acting rationally. And a similar story could apply to the third one too.
But it’s more certain that the first and fourth people are being rational – they act to achieve what they think is in their best interest.
So what is rationality then?
It’s the ability to gauge the Net Present Value of your action and choose the one which maximizes it.
That means, being conscious of the second and third order consequences of your actions as well.
‘Don’t ever take a fence down until you know the reason it was put up.’
G.K Chesterton
You might dislike getting up early, but love going for a run – so you’re able to see the downstream consequences of waking up early and go through with it.
In a nutshell – rationality is being able to choose the best means to your desired end.
And what is rationality not?
Rationality is not about choosing your end.
It’s not more rational to skip junk food than to consume it.
It’s not more rational to wake early and go for a run than sleep late.
It’s not more rational to watch documentaries and read books than play video games.
That’s only an individual preference.
I don’t think you could ever argue from first principles that one choice is “better” than the other. Better for whom? And better why?
That’s why economists usually assume individuals maximize their position on their own utility curve, or they might ask people questions to try to map their utility curves.
But they probably wouldn’t presume to know what people like and dictate to them their utility curves.
Discipline
Is there anything like “self” discipline or “self” control?
It’s always seemed to me to be a word for self-inflicted torture, like people flogging themselves.
Or is it just being rational – assessing the consequences clearly?
Understanding that you don’t mind waking early because going to exercise more than makes up for it.
Or working long hours because what you get in return makes up for it.
Don’t Always Delay
Delaying gratification doesn’t have to be as good as it’s made out to be.
You can end up delaying and delaying till you’re dead and there’s no gratification anymore. Sort of like asceticism.
In some ways, the whole idea of “retirement” is often, but not always, nothing but delaying gratification for most, or a lot, of your life.
Like front-loading the work; work hard now and have fun later.
It sometimes sounds like “discipline” – inflict pain on yourself now for the value that’s lurking in the future.
That’s why most cash flow diagrams look like this.
You put in money, i.e. you lose something today, and you get money back later.
The initial outflow is negative, like the painful first order consequences you undergo today, for the positive third order consequences in the future.
Like waking up early or eating healthy food or working long hours – things you’d normally “dislike” – but do hoping to get something in the future.
This is where these ideas differ from basic finance.
I think it’s possible to have positive first order consequences as well as positive second and third order consequences.
You can like waking up early or avoiding junk or learning things or physically exerting yourself – like it at the present moment, while you’re doing it.
Like it for itself, not for what it might get you one day in the future.
I also think those are the best games to play.
It might not be easy, but it’s possible, at least a lot of the time if not always.
You just have to find the games you like and avoid the ones you don’t, and no one else can do that for you.
But once you’ll find them you’ll probably become good at them because you like playing them, and then work becomes play.