Cognitive Economics and Financial Choices Explaining Portfolio Choice

Cognitive Economics and Financial Choices: Explaining Portfolio Choice and Total Saving Miles Kimball Tyler Shumway Robert Willis

Cognitive Economics: The Economics of What is in People’s Minds

Named by Analogy to “Cognitive Psychology” • Cognitive Psychology = the area of psychology that examines internal mental processes such as problem solving, memory and language. • Cognitive Psychology was a departure from Behaviorism--the idea that only outward behavior is a legitimate object of study. • Milton Friedman famously advocated behaviorism in Economics. 3

Areas of Economics by Distinctive Data Type • Standard Economics (including “Mindless” Psychological Economics a la Gul and Pesendorfer): actual market choices only. • Experimental Economics: choices in artificial situations but with real stakes. • Neuroeconomics: FMRI, saccades, skin conductance, … • Bioeconomics: genes, hormones • Cognitive Economics: mental contents (based on tests and self-reports) and hypothetical choices. 4/65

Four Themes of Cognitive Economics 1. 2. 3. 4. New Types of Data Heterogeneity Finite and Scarce Cognition Welfare Economics Revisited 5/65

3. Finite and Scarce Cognition • Finite cognition=the reality that people are not infinitely intelligent. • Scarce cognition=some decisions required by our modern environment—at work and in private lives—can require more intelligence for full-scale optimization than an individual has 6/65

4. Welfare Economics Revisited • Behavioral economics and finance have found many kinds of anomalous behavior – Exotic preferences? – Cognitive limitations? • Answer matters for welfare and policy • Research strategy of Cognitive Economics: see how much one can explain with cognitive limitations before invoking exotic preferences

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 the common explanation of lack of financial sophistication can account for many behavioral anomalies (“Investor Sophistication and the Home Bias, Diversification and Employer Stock Puzzles”) • The alternative has been a separate explanation for each anomaly.

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 – Ask 16 sophistication questions – Many outcome variables – attitudes & actions

Measuring Sophistication • We count “correct” answers to sophistication questions to form an index • Correct answers are verified by factor analysis and average response • This index is extremely highly correlated with the first component in the factor analysis

T/F Questions with 12 -point Scale

Sophistication Questions 1. Suppose you had $100 in a savings account and the interest rate was 2% per year. After 5 years, how much do you think you would have in the account if you left the money to grow? More than $102? Exactly $102? Less than $102? (. 87) 2. Imagine that the interest rate on your savings account was 1% per year and inflation was 2% per year. After 1 year, would you be able to buy more than, exactly the same as, or less than today with the money in this account? (. 93)

Sophistication Questions (T/F) 3. An investment advisor tells a 30 -year-old couple that $1000 in an investment that pays a certain, constant interest rate would double in value to $2000 after 20 years. If so, that investment would be worth $4000 in less than 45 years. (. 80) 4. When an investor spreads money between 20 stocks rather than 2, the risk of losing a lot of money increases. (. 83)

Sophistication Questions (T/F) 5. If you start out with $1000 and earn an average return of 10% per year for 30 years, the initial $1000 will have grown to less than $6000. (. 66) 6. The more you diversify among stocks, the less of your money you should invest in stocks. (. 61) 7. Mutual funds do not pay a guaranteed rate of return. (. 72) 8. An older person with $100, 000 to invest should hold riskier financial investments than a younger person with $100, 000 to invest. (. 84)

Sophistication Questions (T/F) 9. It is hard to find mutual funds that have annual fees of less than one percent of assets. (. 57) 10. Using money in a bank savings account to pay off credit card debt is usually a good idea. (. 74) 11. You could save money in interest costs by choosing a 30 -year rather than a 15 -year mortgage. (. 90) 12. If the interest rate falls, bond prices will fall. (. 60) 13. Taxes affect how you should invest your money. (. 78)

Foreign Stock Holding Logit Regression, N = 359, Pseudo R 2 = 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 age 2 |. 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 series 2 |. 0001152. 0002339 0. 49 0. 622 risk tolerance |. 1699616. 0620871 2. 74 0. 006 constant | 34. 0129 65. 04428 0. 52 0. 601

Attitude Questions 1. It is a good idea to own stocks of foreign companies (. 71) 2. 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 (. 50) 3. Even older retired people should hold some stocks (. 92) 4. You should invest in either mutual funds or a large number of different stocks instead of just a few stocks (. 76)

Attitude Questions 5. To make money in the stock market, you should not buy and sell stocks too often (. 73) 6. It is important to take a look at your investments periodically to see if you need to make changes (. 93) 7. 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 (. 67)

Attitude Questions 8. Financially, investing in the stock market is no better than buying lottery tickets. (. 90) 9. Even if you are smart, it is hard to pick individual company stocks that will have better than average returns. (. 59) 10. It is possible to invest in the stock market in a way that makes it hard for people to take unfair advantage of you. (. 78)

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 Saving • We looked for a wide range of psychological factors that might affect total saving – Survey Practicum course – Focus groups • Savings questions on the June, 2008 Survey of Consumers

Measuring Propensity to Save Measuring consumption etc. would take more survey time than we had. Instead • 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

Factor Loadings: • Factor | Eigenvalue Difference • • • Factor 1 Factor 2 Factor 3 Factor 4 Factor 5 | | | 3. 64046 1. 61935 1. 36984 0. 79091 0. 71123 2. 02111 0. 24951 0. 57893 0. 07968 0. 05788 Proportion Cumulative 0. 4410 0. 1962 0. 1659 0. 0958 0. 0862 0. 4410 0. 6372 0. 8031 0. 8989 0. 9851

Other Savings Questions: • (. 4097) Compared to people who are similar to you in age, income, and family size, do you think you have more retirement savings, about the same amount of retirement savings, or less retirement savings? [. 43] • (. 0223) Is your current level of spending higher than it should be, about right, or lower than it should be? [. 32] • (. 1894) How much have you thought about retirement –would you say a lot, some, a little, or hardly at all? [-2. 05] • *(Factor Loadings) [Raw Mean]

Other Savings Questions: • (-. 4015) Suppose that the government decided that in addition to current Social Security taxes, everyone under sixty-five who is working would be required to put an additional ten percent of their pre-tax income into a personal retirement account. How hard would it be for you to adjust to your (and your spouse/partner’s) lower take-home pay –- would you say it would be extremely hard, quite hard, somewhat hard, not so hard, or not Hard at all? [-. 16] • (-. 1603) Would you vote for such a program? [. 63]

Other Savings Questions: • Participation in 401 K: (. 3447) Does your employer offer a retirement plan where the money is yours and you can take it with you even if you quit, such as a 401 K or another defined contribution plan? [. 72] Could you have chosen to participate? [. 86] Could you have chosen not to participate? [. 83] • Participation interacted with match rate: (. 3361) If you contributed some of your pay to your retirement account, would your employer match or partially match your contribution? [7. 62] • As a percentage of your pay, what percent do you contribute to your retirement account? (. 1976) [8. 22]

Other Savings Questions: • Contribution level interacted with match rate: (. 1248) Could you contribute more of your pay to your account? [. 66] If you contributed more of your pay to your retirement account, would your employer also contribute more? [. 21] For each extra dollar that you put into your retirement account, how much would your employer put in? [. 86] • Participation in defined benefit plan: (. 0736) Does your employer offer a pension plan, also referred to as a defined benefit plan, that works like Social Security -that is, there is a set of rules that determine how much you will get per month after you retire? [. 32] Could you have chosen not to participate? [. 26] Could you have chosen to participate? [. 86]

Other Savings Questions: • (. 3345) Other than employer retirement plans from current or past employers, do you have anything saved for retirement? [. 57] • (. 3085) What is the total amount you have saved up for retirement, including what you have in retirement accounts such as 401 K’s and IRA’s? [$150, 642] • (. 1957) The last time you (and your family living there) refinanced your mortgage, did you take away money from the closing that you could use for whatever you wanted to use it for? [. 47]

Other Savings Questions: • (. 3691) How often do you (and your family living there) pay the total balance on your monthly credit card bills -would you say always, almost always, most of the time, some of the time, rarely, or never? [2. 71] • (. 1940) Right after you (and your family living there) paid your last credit card bills, how much did you still owe on all of your credit cards? That is, right now how big is the total balance you are carrying to the next month? [$3, 896. 77] • (. 2299) Do you think you would have been better off if you had never gotten a credit card? [. 27]

Other Savings Questions: • (0. 2105) If you unexpectedly received one thousand dollars, would you save it or pay off debt with it? [. 51] • (-. 0103) If you unexpectedly received one thousand dollars, would you save it or have fun with it? [-. 12]

Folk Theories and Cognitive and Psychological Factors We Examine • • • Trust in institutions and others Planning Others will take care of me Saving is good vs. thinking about money is bad Fatalism Social pressure Psychological tricks to encourage saving Self control Budgeting skill Locus of Control

Controls: • All regressions use a savings index as the dependent variable with standard controls Save. Index Coef. Std. Err. T P-value Log Income . 4769 . 1052 4. 53 0. 000 Education . 0003 . 0582 0. 01 0. 995 Age . 0108 . 0051 2. 11 0. 036 Spouse Ed. -. 0041 . 0494 -0. 08 0. 933 Sex -. 0996 . 1140 -0. 87 0. 384 Race 0. 0606 . 0479 1. 26 0. 208 Married -0. 0231 0. 0887 -0. 26 0. 795

Institutional Trust • If I try to save through financial institutions, someone is likely to figure out a way to cheat me out of the money. • Coefficient = -. 15, t-stat = -2. 44

Planning • I enjoy planning for activities like vacations well in advance. (strongly agree. . ) • Coefficient =. 07, t-stat = 1. 44 • Thinking about money stresses me out. • Coefficient = -. 15, t-stat = -3. 07 • I am good at seeing the big picture • Coefficient = 0. 03, t-stat =. 56

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. 09, t-stat = 1. 95 • 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. 06, t-stat = 1. 11 • My children will make sure I am okay financially when I am old. • Coefficient = -0. 01, t-stat = -0. 24

Saving is Good vs. Thinking about Money is Bad (1) • People who don’t save for retirement are being irresponsible • Coefficient = 0. 13, t-stat = 2. 49 • Money doesn’t buy happiness • Coefficient = 0. 08, t-stat = 1. 46 • Using a credit card without paying off the balance every month is really stupid • Coefficient = 0. 11, t-stat = 2. 20

Saving is Good vs. Thinking about Money is Bad (2) • Thinking about money all the time, even when you have enough, is a terrible way to live • Coefficient = 0. 06, t-stat = 1. 23 • Most Americans save too little • Coefficient = 0. 05, t-stat = 0. 87 • Most Americans borrow too much • Coefficient = 0, t-stat = -0. 06

Saving is Good vs. Thinking about Money is Bad (3) • I really respect people who have managed to save a lot of money • Coefficient = -0. 10, t-stat =-1. 98 (wrong sign) • It is nice to have money saved up, but you have to live • Coefficient = -0. 06, t-stat = -1. 28

Fatalism • If you don’t let yourself get too worried, everything tends to work out in the end. • Coefficient = -0. 10, t-stat = -2. 09 • No one can predict the future, so trying to save doesn’t do much good. • Coefficient = -0. 22, t-stat = -4. 71

Social Pressure (1) • My parents or guardians encouraged me to save. • Coefficient = 0. 04, t-stat = 0. 85 • I would hate to have people think I am careless with money. • Coefficient = -0. 09, t-stat = -1. 72 • I would feel guilty about going bankrupt, even if I had to. • Coefficient = -0. 01, t-stat = -0. 24

Social Pressure (2) • When I was growing up, my parents were good at saving their money. • Coefficient = -0. 02, t-stat = -0. 33 • I would hate to have someone think that I am stingy with my money. • Coefficient = -0. 03, t-stat = -0. 67

Psychological Tricks to Encourage Saving • Before I buy something, I ask myself if I am really going to use it. • Coefficient = 0. 03, t-stat = 0. 62 • Pretending to yourself that you have less money than you really do is a good idea. • Coefficient = 0. 01, t-stat = 0. 21 • Before I buy something, I think twice to make sure it is something I really need. • Coefficient = -0. 002, t-stat = -0. 05

Self Control (1) • I often make impulse purchases. • Coefficient = -0. 09, t-stat = -1. 93 • Breaking a rule gives me a feeling of freedom. • Coefficient = -0. 03, t-stat = -0. 62 • I have problems with self control. • Coefficient = -0. 06, t-stat = -1. 09

Self Control (2) • I am very thrifty. • Coefficient = 0. 03, t-stat = 0. 60 • I can stick with a task until it is done, even if it is unpleasant. • Coefficient = 0. 05, t-stat = 0. 97 • I tend to spend more than I should. • Coefficient = -0. 11, t-stat = -2. 22

Budgeting Skill • I often wonder, “Where did all my money go? ” • Coefficient = -0. 14, t-stat = -2. 83

Locus of Control • It is difficult to stay ahead financially because of the things my family members want to buy. • Coefficient = -0. 15, t-stat = -3. 12 • Many of the things that keep me from saving more money are out of my control. • Coefficient = -0. 17, t-stat = -3. 33

Summary: Low Correlation with Propensity to Save • Others will take care of me • Mild statements about desirability of saving • Social pressure • Psychological tricks to encourage saving • Many of the measures of self-control • Some measures of planning propensity: – vacation planning – seeing the big picture

Summary: Promising Questions for Further Investigation (1) • If I try to save through financial institutions, someone is likely to figure out a way to cheat me out of the money. • Thinking about money stresses me out. • Judgmental Statements: – People who don’t save for retirement are being irresponsible – Using a credit card without paying off the balance every month is really stupid

Summary: Promising Questions for Further Investigation (2) • Fatalism – 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. • I tend to spend more than I should. • I often wonder, “Where did all my money go? ”

Summary: Promising Questions for Further Investigation (2) • Fatalism – 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. • I tend to spend more than I should. • Budgeting skill: I often wonder, “Where did all my money go? ”

Summary: Promising Questions for Further Investigation (3) • Locus of Control: – 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.

Conclusion • In a rudimentary R 2 sense, Economics has not been very successful in explaining portfolio choice or high vs. low saving. • Measuring what is in people’s minds provides insight into what kinds of additional factors might help explain portfolio choice and total saving.

Explaining Portfolio Choice: Kimball, Sahm, Shapiro (JASA, 2008)

Laurie Pounder (2006): High and Low Savers? Circumstances, Patience and Cognition

Average Propensity to Consume Out of Full Modigliani Wealth (Kreps-Porteus Preferences)