Cognitive Economics and Financial Choices: Explaining Portfolio Choice and Total Saving

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Cognitive Economics and Financial
ChoicesExplaining Portfolio Choice and Total
Saving

• Miles Kimball
• Tyler Shumway
• Robert Willis

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Explaining Portfolio Choice Kimball, Sahm,
Shapiro (JASA, 2008)
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Laurie Pounder (2006) High and Low Savers?
Circumstances, Patience and Cognition
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Average Propensity to Consume Out of Full
Modigliani Wealth(Kreps-Porteus Preferences)
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Cognitive EconomicsThe Economics of What is in
Peoples Minds
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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.

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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.

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Four Themes of Cognitive Economics

• New Types of Data
• Heterogeneity
• Finite and Scarce Cognition
• Welfare Economics Revisited

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3. Finite and Scarce Cognition

• Finite cognitionthe reality that people are not
  infinitely intelligent.
• Scarce cognitionsome decisions required by our
  modern environmentat work and in private
  livescan require more intelligence for
  full-scale optimization than an individual has

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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

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Dimensions of Cognition

• Sophistication (some say literacy)
• Distance from truth
• Overconfidence
• Awareness of distance from truth
• Folk theories
• Direction of departure from truth

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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.

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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

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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

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T/F Questions with 12-point Scale
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Sophistication Questions

• 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?
• 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?

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Sophistication Questions (T/F)

• 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.
• Financially, investing in the stock market is no
  better than buying lottery tickets.
• When an investor spreads money between 20 stocks
  rather than 2, the risk of losing a lot of money
  increases.

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Sophistication Questions (T/F)

1. 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.
2. The more you diversify among stocks, the less of
   your money you should invest in stocks.
3. Mutual funds do not pay a guaranteed rate of
   return.
4. An older person with 100,000 to invest should
   hold riskier financial investments than a younger
   person with 100,000 to invest.

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Sophistication Questions (T/F)

1. It is hard to find mutual funds that have annual
   fees of less than one percent of assets.
2. Even if you are smart, it is hard to pick
   individual company stocks that will have better
   than average returns.
3. Using money in a bank savings account to pay off
   credit card debt is usually a good idea.
4. You could save money in interest costs by
   choosing a 30-year rather than a 15-year mortgage.

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Sophistication Questions (T/F)

1. It is possible to invest in the stock market in a
   way that makes it hard for people to take unfair
   advantage of you.
2. If the interest rate falls, bond prices will
   fall.
3. Taxes affect how you should invest your money.

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Foreign Stock Holding
Logit Regression, N 359, Pseudo R2
0.1596 -------------------------------------------
-----------------------------------
Coef. Std. Err. z Pgtz
------------------------------------------------
-------- 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
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Attitude Questions

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

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Attitude Questions

1. To make money in the stock market, you should not
   buy and sell stocks too often
2. It is important to take a look at your
   investments periodically to see if you need to
   make changes
3. 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

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Other Regressions
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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)

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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)

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Overconfidence Questions
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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

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Overconfidence Regressions 1
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Overconfidence Regressions 2
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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

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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

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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

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Responses to Hypotheticals
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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

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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)

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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/partners) 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)

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Other Savings Questions

• Participation in 401K 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)
• Participation interacted with match rate 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)

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Other Savings Questions

• Contribution level interacted with match rate
  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)
• Participation in defined benefit plan 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)

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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 401Ks and IRAs? (.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)

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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)

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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)

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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

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Controls

• All regressions use a savings index as the
  dependent variable with standard controls

SaveIndex 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
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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

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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

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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

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Saving is Good vs. Thinking about Money is Bad (1)

• People who dont save for retirement are being
  irresponsible
• Coefficient 0.13, t-stat 2.49
• Money doesnt 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

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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

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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
• It is nice to have money saved up, but you have
  to live
• Coefficient -0.06, t-stat -1.28

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Fatalism

• If you dont 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
  doesnt do much good.
• Coefficient -0.22, t-stat -4.71

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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

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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

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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

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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

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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

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Budgeting Skill

• I often wonder, Where did all my money go?
• Coefficient -0.14, t-stat -2.83

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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

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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

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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 dont save for retirement are being
  irresponsible
• Using a credit card without paying off the
  balance every month is really stupid

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Summary Promising Questions for Further
Investigation (2)

• Fatalism
• If you dont let yourself get too worried,
  everything tends to work out in the end.
• No one can predict the future, so trying to save
  doesnt do much good.
• I tend to spend more than I should.
• I often wonder, Where did all my money go?

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Summary Promising Questions for Further
Investigation (2)

• Fatalism
• If you dont let yourself get too worried,
  everything tends to work out in the end.
• No one can predict the future, so trying to save
  doesnt do much good.
• I tend to spend more than I should.
• Budgeting skill I often wonder, Where did all
  my money go?

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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.

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Conclusion

• In a rudimentary R2 sense, Economics has not been
  very successful in explaining portfolio choice or
  high vs. low saving.
• Measuring what is in peoples minds provides
  insight into what kinds of additional factors
  might help explain portfolio choice and total
  saving.