Cognitive Economics and Financial Choices Miles Kimball Tyler Shumway

Cognitive Economics The economics of what is in people’s minds Explicitly allows people to have limited cognitive abilities –Mistakes and folk theories –Limited knowledge of economic realities –Bounded rationality, rational ignorance We measure knowledge and correlate it with behavior that appears suboptimal

Cognitive and Behavioral Econ Behavioral economics and finance have found lots of anomalous behavior –Weird preferences? –Cognitive limitations? Answer matters for welfare and policy Cognitive economics: see how much we can explain with cognitive limitations before invoking weird preferences

Dimensions of Cognition We explore three dimensions of cognition Sophistication (some say literacy) –Distance from truth Overconfidence –Awareness of distance from truth Folk theories –Direction of departure from truth

Financial Sophistication We hypothesize that sophistication can explain numerous behavioral regularities –People make mistakes Simpler explanation than alternatives –Information structure –Unusual incentives or weird preferences

Measuring Sophistication Previous work of Hilgert, Hogarth and Beverly (2003), Lusardi and Mitchell (2007) Questions on the April 2005 Survey of Consumers – Kimball and Shumway (2007) Fox Run Survey, ALP used for development Cognitive Economics Survey –About 15 sophistication questions –Many outcome variables – attitudes & actions

Measuring Sophistication We count “correct” answers to sophistication questions to form an index This index is extremely highly correlated with the first component in a factor analysis We omit “attitudinal outcome” questions (we use CogEcon questions and 41)

Foreign Stock Holding Logit Regression, N = 359, Pseudo R 2 = | Coef. Std. Err. z P>|z| fin sophist | ln(income) | ln(fin wealth) | age | age 2 | use the web | female | education | econ classes | married | number series | number series 2 | risk tolerance | constant |

Attitude Questions It is a good idea to own stocks of foreign companies An employee of a company with publicly traded stock should have little or none of his or her retirement savings in the company’s stock Even older retired people should hold some stocks You should invest in either mutual funds or a large number of different stocks instead of just a few stocks

Attitude Questions To make money in the stock market, you should not buy and sell stocks too often It is important to take a look at your investments periodically to see if you need to make changes If inflation is not an issue, it is better for young people saving for retirement to combine stocks with long-term bonds than with short-term bonds

Other Regressions

Sophistication and Choice Portfolio choice appears to be significantly affected by sophistication Less sophisticated people make mistakes Causality may be an issue for some of these, but not for all of them Education may help to remedy this, or better policy (defaults, etc)

Overconfidence Overconfidence is thought to be a significant factor in financial decisions Typically not measured very well –Gender (Barber and Odean, 2001) –Excessive trading –Old military records (Grinblatt and Keloharju, 2008)

Overconfidence Questions

Measuring Overconfidence Accuracy Overconfidence: The difference between the average probability of a correct answer and the actual fraction Self-Rated Overconfidence: Residual of regression of percent correct on self-rating variables, math score, demographics Return Overconfidence: Return I can get – return average individual can get

Overconfidence Regressions 1

Overconfidence Regressions 2

Overconfidence and Choice Overconfidence is clearly related to a number of portfolio choices –Stock and cash holdings –Trading frequency Contrary to other findings, not significantly related to gender or momentum trading

Total Savings and Folk Theories We hypothesize that total savings rates and stocks are affected by folk theories –Survey Practicum course –Focus groups Savings questions on the Survey of Consumers for June

Measuring Propensity to Save Make an index of many “outcome variables” 79% of variance is explained with responses to two hypothetical questions: –Suppose you got a (new) job that has a 401(k) retirement savings plan. You can contribute up to 10% of your pay. For every dollar you put in, your (new) employer will put in a dollar. What percentage of your pay would you choose to contribute? –Same question with a twenty-five cent match

Responses to Hypotheticals

Folk Theories we Examine Trust of institutions and others Planning Others will take care of me Saving is inherently good (almost morally) Fatalism Social pressure Psychological tricks Self control Budgeting skill Control

Institutional Trust All regressions use a savings index as the dependent variable, no other controls If I try to save through financial institutions, someone is likely to figure out a way to cheat me out of the money. Coefficient = -0.67, t-stat = -3.38

Planning I enjoy planning for activities like vacations well in advance. (strongly agree..) Coefficient = 0.53, t-stat = 2.66 Thinking about money stresses me out. Coefficient = -1.25, t-stat = I am good at seeing the big picture Coefficient = 0.72, t-stat = 2.43

Others Will Take Care of Me Whether for political or other reasons, the US government will always make sure that senior citizens have basic food, shelter, clothing, and medical care. Coefficient = 0.26, t-stat = 1.47 Even in the worst case, I will be okay financially when I am old because I will have government programs to fall back on. Coefficient = -0.02, t-stat = My children will make sure I am okay financially when I am old. Coefficient = -0.16, t-stat = -0.73

Saving is Good (1) People who don’t save for retirement are being irresponsible Coefficient = 1.04, t-stat = 5.14 Money doesn’t buy happiness Coefficient = 0.43, t-stat = 1.82 Using a credit card without paying off the balance every month is really stupid Coefficient = 0.63, t-stat = 3.19

Saving is Good (2) Thinking about money all the time, even when you have enough, is a terrible way to live Coefficient = 0.30, t-stat = 1.28 Most Americans save too little Coefficient = 0.96, t-stat = 3.13 Most Americans borrow too much Coefficient = 0.30, t-stat = 0.93

Saving is Good (3) I really respect people who have managed to save a lot of money Coefficient = -0.27, t-stat =-0.89 It is nice to have money saved up, but you have to live Coefficient = -0.85, t-stat = -2.84

Fatalism If you don’t let yourself get too worried, everything tends to work out in the end. Coefficient = -0.40, t-stat = No one can predict the future, so trying to save doesn’t do much good. Coefficient = -1.51, t-stat = -5.64

Social Pressure (1) My parents or guardians encouraged me to save. Coefficient = 0.24, t-stat = 1.17 I would hate to have people think I am careless with money. Coefficient = -0.08, t-stat = I would feel guilty about going bankrupt, even if I had to. Coefficient = 0.45, t-stat = 2.22

Social Pressure (2) When I was growing up, my parents were good at saving their money. Coefficient = 0.17, t-stat = 0.98 I would hate to have someone think that I am stingy with my money. Coefficient = 0.03, t-stat = 0.15

Psychological Tricks Before I buy something, I ask myself if I am really going to use it. Coefficient = 0.33, t-stat = 1.31 Pretending to yourself that you have less money than you really do is a good idea. Coefficient = -0.21, t-stat = Before I buy something, I think twice to make sure it is something I really need. Coefficient = 0.01, t-stat = 0.02

Self Control (1) I often make impulse purchases. Coefficient = -0.55, t-stat = Breaking a rule gives me a feeling of freedom. Coefficient = -0.23, t-stat = I have problems with self control. Coefficient = -0.37, t-stat = -1.39

Self Control (2) I am very thrifty. Coefficient = -0.09, t-stat = I can stick with a task until it is done, even if it is unpleasant. Coefficient = 0.61, t-stat = 2.06 I tend to spend more than I should. Coefficient = -0.56, t-stat = -2.78

Budgeting Skill I often wonder, “Where did all my money go?” Coefficient = -0.74, t-stat = -4.10

Control It is difficult to stay ahead financially because of the things my family members want to buy. Coefficient = -0.97, t-stat = Many of the things that keep me from saving more money are out of my control. Coefficient = -1.00, t-stat = -5.62

Folk Theories These results are preliminary –Need to adjust for income –Create factors for different theories to explore Still, we can see some things –Trust, planning, fatalism and control important –People are not hypocritical (at least in surveys) Folk theories appear to matter

Conclusion Cognitive economics posits that cognition is an important consideration in economic decision making We have good evidence that sophistication, overconfidence, and folk theories drive some decisions This has important implications