Cognitive Economics and
Financial Choices:
Explaining Portfolio Choice and
Total Saving
Miles Kimball
Tyler Shumway
Robert Willis
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)
C
 EIS    (1  EIS)   r  .5  RRT  (Sharpe Ratio)2 
M
C  Consumption
M  Present Value of Lifetime Resources
EIS  Elasticity of Intertemporal Substitution
  Time Discount Rate
r  Real Interest Rate
RRT= Relative Risk Tolerance
Sharpe Ratio = Risk Premium/Standard Deviation
on the Mean-Variance Efficient Frontier
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.
9
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.
10/65
Four Themes of Cognitive
Economics
1.
2.
3.
4.
New Types of Data
Heterogeneity
Finite and Scarce Cognition
Welfare Economics Revisited
11/65
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
12/65
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
An example of a true-false statement is the following:
Example Statement: A savings bank never offers a checking account.
Most Likely False
Surely
False
Most Likely True
Guess
False
100% 90% 80% 70% 60% 50%
Guess True
Surely
True
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%.
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?
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?
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.
4. Financially, investing in the stock market is no
better than buying lottery tickets.
5. When an investor spreads money between 20
stocks rather than 2, the risk of losing a lot of
money increases.
Sophistication Questions (T/F)
6. 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.
7. The more you diversify among stocks, the less
of your money you should invest in stocks.
8. Mutual funds do not pay a guaranteed rate of
return.
9. An older person with $100,000 to invest should
hold riskier financial investments than a younger
person with $100,000 to invest.
Sophistication Questions (T/F)
10. It is hard to find mutual funds that have annual
fees of less than one percent of assets.
11. Even if you are smart, it is hard to pick individual
company stocks that will have better than
average returns.
12. Using money in a bank savings account to pay
off credit card debt is usually a good idea.
13. You could save money in interest costs by
choosing a 30-year rather than a 15-year
mortgage.
Sophistication Questions (T/F)
14. It is possible to invest in the stock market in a
way that makes it hard for people to take unfair
advantage of you.
15. If the interest rate falls, bond prices will fall.
16. Taxes affect how you should invest your
money.
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
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 company’s 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
Attitude Questions
5. To make money in the stock market, you
should not buy and sell stocks too often
6. It is important to take a look at your
investments periodically to see if you need to
make changes
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
Other Regressions
Dependent Variable
Mean Coefficient P-value Obs
Holds Foreign Stock
0.52
2.51
0.026
359
Foreign Stock Att
0.71
3.05
0.000
663
Holds Employer Stock
0.67
-2.01
0.519
64
Employer Stock Att
0.50
1.31
0.058
592
Stock Share of Wealth
0.38
0.07
0.535
557
Participation Att
0.92
1.87
0.119
667
Diversification
0.87
0.32
0.000
449
Diversification Att
0.76
4.19
0.000
668
Ever Trades Stock?
0.48
2.67
0.002
547
Trade Frequency
4.49
-0.91
0.404
306
Frequent Trade Att
0.73
5.93
0.000
312
Inertia Att
0.93
2.83
0.017
667
Holds Long Term Bonds
0.30
2.07
0.044
393
Long Term Bond Att
0.67
0.09
0.889
660
Highest Interest Paid
6.23
-6.90
0.001
583
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
An example of a true-false statement is the following:
Example Statement: A savings bank never offers a checking account.
Most Likely False
Surely
False
Most Likely True
Guess
False
100% 90% 80% 70% 60% 50%
Guess True
Surely
True
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 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
Dependent Variable
Overconf Coeff P-value Obs
Accuracy
0.284
0.622
63
Stock Fraction (w/o Empl) Self-Rated
3.299
0.018
62
Return
-0.007
0.899
62
Accuracy
0.060
0.620 357
Foreign Stock Fraction Self-Rated
0.034
0.913 356
Return
0.004
0.618 358
Accuracy
0.091
0.443 444
Diversification
Self-Rated
0.234
0.448 439
Return
-0.006
0.479 441
Accuracy
-1.311
0.053
72
Momentum Trader?
Self-Rated -1.691
0.411
72
Return
-0.042
0.399
72
Accuracy
0.026
0.770 545
Bonds Fraction
Self-Rated
0.388
0.107 532
Return
0.010
0.140 543
Accuracy
-0.500
0.004 545
Cash Fraction
Self-Rated -1.390
0.002 532
Return
-0.026
0.054 543
Accuracy
0.316
0.065 382
LT Bonds Fraction
Self-Rated
0.575
0.203 372
Return
0.022
0.101 382
Overconfidence Regressions 2
Dependent Variable
Trade Frequency
Ever Trades?
Highest Interest Paid
Debt to Income Ratio
At least 1/3 Stocks
At least 1/3 Bonds
At least 1/3 Cash
Overconf Coeff
P-value Obs
Accuracy
6.999
0.102
53
Self-Rated
2.080
0.833
53
Return
-0.190
0.585
53
Accuracy
0.558
0.005 623
Self-Rated
2.317
0.000 605
Return
0.017
0.294 619
Accuracy
0.392
0.883 651
Self-Rated
-8.944
0.192 632
Return
-0.086
0.694 646
Accuracy
263.747
0.013 574
Self-Rated
297.316
0.282 560
Return
-2.058
0.810 568
Accuracy
0.334
0.106 628
Self-Rated
1.425
0.007 610
Return
0.015
0.370 624
Accuracy
-0.002
0.993 625
Self-Rated
-0.134
0.752 607
Return
0.000
1.000 621
Accuracy
-0.512
0.019 624
Self-Rated
-1.737
0.002 607
Return
-0.073
0.000 621
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
Match
Percent
0
1
2
3
4
5
6
7
8
9
10
Total
1 Dollar
Match
3
1
6
10
1
39
7
9
6
0
275
357
25 Cent
Match
14
5
10
22
8
52
12
8
8
1
221
361
Factor Loadings:
•
Factor
| Eigenvalue Difference
•
•
•
•
•
Factor1
Factor2
Factor3
Factor4
Factor5
|
|
|
|
|
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:
• 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)
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)
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)
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)
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)
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)
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)
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
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
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
• 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 R2 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.