Download ppt - Cognitive Economics and Financial Choices Miles Kimball Tyler Shumway

Cognitive Economics and Cognitive Economics and Financial ChoicesFinancial Choices

Miles KimballMiles Kimball

Tyler ShumwayTyler Shumway

Cognitive EconomicsCognitive 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 EconCognitive 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 CognitionDimensions 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 SophisticationFinancial 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 SophisticationMeasuring 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 SophisticationMeasuring 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 15-30 and 41)

Foreign Stock HoldingForeign Stock Holding

Logit Regression, N = 359, Pseudo R2 = 0.1596------------------------------------------------------------------------------

| Coef. Std. Err. z P>|z|

-------------+-------------------------------------------

fin sophist | 2.508706 1.129884 2.22 0.026 ln(income) | -.0028919 .0882921 -0.03 0.974

ln(fin wealth) | .4421791 .0960877 4.60 0.000

age | -.2720059 .1587194 -1.71 0.087

age2 | .0019148 .001196 1.60 0.109

use the web | 1.162134 .3712195 3.13 0.002

female | -.0374495 .2566188 -0.15 0.884

education | .1065741 .071805 1.48 0.138

econ classes | -.0417273 .054217 -0.77 0.442

married | -.390569 .3198808 -1.22 0.222

number series | -.1275469 .2467387 -0.52 0.605

number series2 | .0001152 .0002339 0.49 0.622

risk tolerance | .1699616 .0620871 2.74 0.006

constant | 34.0129 65.04428 0.52 0.601

Attitude QuestionsAttitude 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 QuestionsAttitude 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 RegressionsOther RegressionsDependent Variable Mean Coefficient P-value ObsHolds Foreign Stock 0.52 2.51 0.026 359Foreign Stock Att 0.71 3.05 0.000 663Holds Employer Stock 0.67 -2.01 0.519 64Employer Stock Att 0.50 1.31 0.058 592Stock Share of Wealth 0.38 0.07 0.535 557Participation Att 0.92 1.87 0.119 667Diversification 0.87 0.32 0.000 449Diversification Att 0.76 4.19 0.000 668Ever Trades Stock? 0.48 2.67 0.002 547Trade Frequency 4.49 -0.91 0.404 306Frequent Trade Att 0.73 5.93 0.000 312Inertia Att 0.93 2.83 0.017 667Holds Long Term Bonds 0.30 2.07 0.044 393Long Term Bond Att 0.67 0.09 0.889 660Highest Interest Paid 6.23 -6.90 0.001 583

Sophistication and ChoiceSophistication 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)

OverconfidenceOverconfidence

• 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 QuestionsOverconfidence Questions

An example of a true-false statement is the following: Example Statement: A savings bank never offers a checking account.

Most Likely False Most Likely True Surely False

Guess False

Guess True Surely

True

100% 90% 80% 70% 60% 50%

50% 60% 70% 80% 90% 100%

Please Circle One Number If you think that this statement is most likely to be true, please choose a number in the right half of the box above. If you think that the statement is surely true circle “100%”. If you think it is only 60% likely to be true, please circle 60%.

Measuring OverconfidenceMeasuring 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 1Overconfidence Regressions 1Dependent Variable Overconf Coeff P-value Obs

Accuracy 0.284 0.622 63Self-Rated 3.299 0.018 62Return -0.007 0.899 62Accuracy 0.060 0.620 357Self-Rated 0.034 0.913 356Return 0.004 0.618 358Accuracy 0.091 0.443 444Self-Rated 0.234 0.448 439Return -0.006 0.479 441Accuracy -1.311 0.053 72Self-Rated -1.691 0.411 72Return -0.042 0.399 72Accuracy 0.026 0.770 545Self-Rated 0.388 0.107 532Return 0.010 0.140 543Accuracy -0.500 0.004 545Self-Rated -1.390 0.002 532Return -0.026 0.054 543Accuracy 0.316 0.065 382Self-Rated 0.575 0.203 372Return 0.022 0.101 382

Momentum Trader?

Bonds Fraction

Cash Fraction

LT Bonds Fraction

Stock Fraction (w/o Empl)

Foreign Stock Fraction

Diversification

Overconfidence Regressions 2Overconfidence Regressions 2Dependent Variable Overconf Coeff P-value Obs

Accuracy 6.999 0.102 53Self-Rated 2.080 0.833 53Return -0.190 0.585 53Accuracy 0.558 0.005 623Self-Rated 2.317 0.000 605Return 0.017 0.294 619Accuracy 0.392 0.883 651Self-Rated -8.944 0.192 632Return -0.086 0.694 646Accuracy 263.747 0.013 574Self-Rated 297.316 0.282 560Return -2.058 0.810 568Accuracy 0.334 0.106 628Self-Rated 1.425 0.007 610Return 0.015 0.370 624Accuracy -0.002 0.993 625Self-Rated -0.134 0.752 607Return 0.000 1.000 621Accuracy -0.512 0.019 624Self-Rated -1.737 0.002 607Return -0.073 0.000 621

Ever Trades?

At least 1/3 Cash

Trade Frequency

Highest Interest Paid

Debt to Income Ratio

At least 1/3 Stocks

At least 1/3 Bonds

Overconfidence and ChoiceOverconfidence 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 TheoriesTotal 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 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 HypotheticalsResponses to HypotheticalsMatch 1 Dollar 25 Cent

Percent Match Match0 3 141 1 52 6 103 10 224 1 85 39 526 7 127 9 88 6 89 0 110 275 221Total 357 361

Folk Theories we ExamineFolk 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 TrustInstitutional 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

PlanningPlanning

• 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.


• I am good at seeing the big picture


Others Will Take Care of MeOthers 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 = -0.07• My children will make sure I am okay financially when I

am old.• Coefficient = -0.16, t-stat = -0.73

Saving is Good (1)Saving is Good (1)

• People who don’t save for retirement are being irresponsible


• Money doesn’t buy happiness


• Using a credit card without paying off the balance every month is really stupid



• Thinking about money all the time, even when you have enough, is a terrible way to live


• Most Americans save too little


• Most Americans borrow too much



• 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


FatalismFatalism

• If you don’t let yourself get too worried, everything tends to work out in the end.


• No one can predict the future, so trying to save doesn’t do much good.


Social Pressure (1)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 = -0.36• I would feel guilty about going bankrupt, even if I

had to.• Coefficient = 0.45, t-stat = 2.22

Social Pressure (2)Social Pressure (2)

• When I was growing up, my parents were good at saving their money.


• I would hate to have someone think that I am stingy with my money.


Psychological TricksPsychological 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 = -1.06• 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)Self Control (1)

• I often make impulse purchases.


• Breaking a rule gives me a feeling of freedom.


• I have problems with self control.


Self Control (2)Self Control (2)

• I am very thrifty.


• I can stick with a task until it is done, even if it is unpleasant.


• I tend to spend more than I should.


Budgeting SkillBudgeting Skill

• I often wonder, “Where did all my money go?”


ControlControl

• It is difficult to stay ahead financially because of the things my family members want to buy.


• Many of the things that keep me from saving more money are out of my control.


Folk TheoriesFolk 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

ConclusionConclusion

• 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