Cognitive Economics and Financial Choices

1. Cognitive Economics and Financial Choices Miles Kimball Tyler Shumway

2. 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

3. 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

4. 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

5. 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

6. 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

7. 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 15-30 and 41)

8. Foreign 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

9. 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

10. 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

11. Other Regressions

12. 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)

13. 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)

14. Overconfidence Questions

15. 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

16. Overconfidence Regressions 1

17. Overconfidence Regressions 2

18. 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

19. 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

20. 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

21. Responses to Hypotheticals

22. Factor Loadings: • Factor | Eigenvalue Difference Proportion Cumulative • Factor1 | 3.64046 2.02111 0.4410 0.4410 • Factor2 | 1.61935 0.24951 0.1962 0.6372 • Factor3 | 1.36984 0.57893 0.1659 0.8031 • Factor4 | 0.79091 0.07968 0.0958 0.8989 • Factor5 | 0.71123 0.05788 0.0862 0.9851

23. Other Savings Questions: • 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? (.4097)* • Is your current level of spending higher than it should be, about right,or lower than it should be? (.0223) • How much have you thought about retirement –- would you say a lot, some, a little, or hardly at all? (.1894) • *(Factor Loadings)

24. Other Savings Questions: • 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? (-.4015) • Would you vote for such a program? (-.1603)

25. Other Savings Questions: • 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 401K or another defined contribution plan? Could you have chosen to participate? Could you have chosen not to participate? (.3447) • If you contributed some of your pay to your retirement account, would your employer match or partially match your contribution? (.3361) • As a percentage of your pay, what percent do you contribute to your retirement account? (.1976)

26. Other Savings Questions: • Could you contribute more of your pay to your account? If you contributed more of your pay to your retirement account, would your employer also contribute more? For each extra dollar that you put into your retirement account, how much would your employer put in? (.1248) • 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? Could you have chosen not to participate? Could you have chosen to participate? (.0736)

27. Other Savings Questions: • Other than employer retirement plans from current or past employers, do you have anything saved for retirement? (.3345) • What is the total amount you have saved up for retirement, including what you have in retirement accounts such as 401K’s and IRA’s? (.3085) • 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? (.1957)

28. Other Savings Questions: • 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? (.3691) • 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? (.1940) • Do you think you would have been better off if you had never gotten a credit card? (.2299)

29. Other Savings Questions: • If you unexpectedly received one thousand dollars, would you save it, pay off debt with it, pay bills with it, or have fun with it? (0.2105) • If you unexpectedly received one thousand dollars, would you save it, pay off debt with it, pay bills with it, or have fun with it? (-.0103)

30. 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

31. Controls: • All regressions use a savings index as the dependent variable with standard controls

32. 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

33. Planning • I enjoy planning for activities like vacations well in advance. (strongly agree ..) • Coefficient = .68, 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

34. 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

35. Saving is Good (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

36. Saving is Good (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

37. Saving is Good (3) • I really respect people who have managed to save a lot of money • Coefficient = -0.10, t-stat =-1.98 • It is nice to have money saved up, but you have to live • Coefficient = -0.06, t-stat = -1.28

38. 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

39. 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

40. 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

41. Psychological Tricks • 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

42. 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

43. 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

44. Budgeting Skill • I often wonder, “Where did all my money go?” • Coefficient = -0.14, t-stat = -2.83

45. 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

46. 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

47. 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