Hostname: page-component-76fb5796d-dfsvx Total loading time: 0 Render date: 2024-04-25T08:10:26.641Z Has data issue: false hasContentIssue false
  • English
  • Français

Hyperbolic discounting and life-cycle portfolio choice*

Published online by Cambridge University Press:  01 October 2015

DAVID LOVE  and
GREGORY PHELAN
DAVID LOVE
Affiliation:
Williams College, Williamstown, MA 01267, USA (e-mail: david.love@williams.edu, gregory.phelan@williams.edu)
GREGORY PHELAN
Affiliation:
Williams College, Williamstown, MA 01267, USA (e-mail: david.love@williams.edu, gregory.phelan@williams.edu)
Get access Rights & Permissions [Opens in a new window]

Abstract

This paper studies how hyperbolic discounting affects stock market participation, asset allocation, and saving decisions over the life cycle in an economy with Epstein–Zin preferences. Hyperbolic discounting affects saving and portfolio decisions through at least two channels: (1) it lowers desired saving, which decreases financial wealth relative to future earnings; and (2) it lowers the incentive to pay a fixed cost to enter the stock market. We find that hyperbolic discounters accumulate less wealth relative to their geometric counterparts and that they participate in the stock market at a later age. Because they have lower levels of financial wealth relative to future earnings, hyperbolic discounters who do participate in the stock market tend to hold a higher share of equities, particularly in the retirement years. We find that increasing the elasticity of intertemporal substitution, holding risk aversion constant, greatly magnifies the impact of hyperbolic discounting on all of the model's decision rules and simulated levels of participation, allocation, and wealth. Finally, we introduce endogenous financial knowledge accumulation and find that hyperbolic discounting leads to lower financial literacy and inefficient stock market investment.

Keywords

G11G22D91E21Hyperbolic discountingEpstein–Zinportfolio choicefinancial literacy
Type
Articles
Information
Journal of Pension Economics & Finance , Volume 14 , Special Issue 4: Household Finance , October 2015 , pp. 492 - 524
Copyright
Copyright © Cambridge University Press 2015 

Access options

Get access to the full version of this content by using one of the access options below. (Log in options will check for institutional or personal access. Content may require purchase if you do not have access.)

Footnotes

*

We are grateful for the excellent research assistance of Jesse Freeman and Rebecca Lewis.

References

Agarwal, S., Driscoll, J. C., Gabaix, X. and Laibson, D. (2009) The Age of Reason: Financial Decisions over the Life Cycle and Implications for Regulation. Brookings Papers on Economic Activity 2009, pp. 51–101.Google Scholar
Ameriks, J. and Zeldes, S. P. (2004) How do household portfolio shares vary with age? Working Paper: Columbia University GSB.Google Scholar
Angeletos, G.-M., Laibson, D., Repetto, A., Tobacman, J. and Weinberg, S. (2001) The hyperbolic consumption model: calibration, simulation, and empirical evaluation. Journal of Economic Perspectives, 15(3): 47–68.Google Scholar
Barro, R. J. (1999) Ramsey meets laibson in the neoclassical growth model. Quarterly Journal of Economics, 114(4): 1125–1152.Google Scholar
Calvet, L. E., Campbell, J. Y. and Sodini, P. (2007) Down or out: assessing the welfare costs of household investment mistakes. Journal of Political Economy, 115(5): 707–747.Google Scholar
Campbell, J. Y. and Viceira, L. M. (1999) Consumption and portfolio decisions when expected returns are time varying. Quarterly Journal of Economics, 114(2): 433–495.Google Scholar
Carroll, C. D. (1992) The buffer-stock theory of saving: some macroeconomic evidence. Brookings Papers on Economic Activity, 1992(2): 61–156.Google Scholar
Carroll, C. D. (1997) Buffer-stock saving and the life cycle/permanent income hypothesis. Quarterly Journal of Economics, 112(1): 1–55.Google Scholar
Carroll, C. D. (2006) The method of endogenous gridpoints for solving dynamic stochastic optimization problems. Economics Letters, 91(3): 312–320.Google Scholar
Carroll, C. D. (2008) Lecture notes on solution methods for microeconomic dynamic stochastic optimization problems. Working Paper: Johns Hopkins University.Google Scholar
Carroll, C. D. and Samwick, A. A. (1997) The nature of precautionary wealth. Journal of Monetary Economics, 40(1): 41–71.Google Scholar
Cocco, J. F. (2005) Portfolio choice in the presence of housing. Review of Financial Studies, 18(2): 535–567.Google Scholar
Cocco, J. F., Gomes, F. J. and Maenhout, P. J. (2005) Consumption and portfolio choice over the life cycle. Review of Financial Studies, 18(2): 491–533.Google Scholar
Diamond, P. and Köszegi, B. (2003) Quasi-hyperbolic discounting and retirement. Journal of Public Economics, 87(9): 1839–1872.Google Scholar
Epstein, L. G. and Zin, S. E. (1989) Substitution, risk aversion, and the temporal behavior of consumption and asset returns: a theoretical framework. Econometrica, 57(4): 937–969.Google Scholar
Frederick, S., Loewenstein, G. and O'Donoghue, T. (2002) Time discounting and time preference: a critical review. Journal of Economic Literature, 40(2): 351–401.Google Scholar
Gaudecker, H.-M. v. (2015) How does household portfolio diversification vary with financial literacy and financial advice? Journal of Finance, 70(2): 489–507.Google Scholar
Geraats, P. M. (2006) Intertemporal substitution and hyperbolic discounting. Cambridge Working Papers in Economics (CWPE) 0515.Google Scholar
Gomes, F. J. and Michaelides, A. (2005) Optimal life-cycle asset allocation: understanding the empirical evidence. Journal of Finance, 60(2): 869–904.Google Scholar
Guiso, L. and Viviano, E. (2014) How Much Can Financial Literacy Help? Review of Finance. http://rof.oxfordjournals.org/content/early/2014/08/23/rof.rfu033.full.pdf+html.Google Scholar
Haliassos, M. and Michaelides, A. (2003) Portfolio choice and liquidity constraints. International Economic Review, 44(1): 143–177.Google Scholar
Harris, C. and Laibson, D. (2001) Dynamic choices of hyperbolic consumers. Econometrica, 69(4): 935–957.Google Scholar
Harris, C. J. and Laibson, D. (2002) Hyperbolic discounting and consumption. In Dewatripont, Mathias, Hansen, Lars Peter, and Turnovsky, Stephen (eds), Advances in Economics and Econometrics: Theory and Applications, Volume 1. Eighth World Congress, pp. 258–298. http://scholar.harvard.edu/laibson/publications/hyperbolic-discounting-and-consumption.Google Scholar
Hastings, J. S. and Mitchell, O. S. (2011) How financial literacy and impatience shape retirement wealth and investment behaviors. Tech. Rep., National Bureau of Economic Research.Google Scholar
Heaton, J. and Lucas, D. (2000) Portfolio choice in the presence of background risk. Economic Journal, 110: 1–26.Google Scholar
Jappelli, T. and Padula, M. (2013) Investment in financial literacy and saving decisions. Journal of Banking and Finance, 37(8): 2779–2792.Google Scholar
Kim, H. H., Maurer, R. and Mitchell, O. S. (2013) Time is money: life cycle rational inertia and delegation of investment management. Tech. Rep., National Bureau of Economic Research.Google Scholar
Kimball, M. S. and Shumway, T. (2010) Investor sophistication and the home bias, diversification, and employer stock puzzles. Tech. Rep., University of Michigan Working Paper.Google Scholar
Korniotis, G. M. and Kumar, A. (2011) Do older investors make better investment decisions? Review of Economics and Statistics, 93(1): 244–265.Google Scholar
Laibson, D. (1997) Golden eggs and hyperbolic discounting. Quarterly Journal of Economics 112(2, In Memory of Amos Tversky, (1937–1996)): 443–477.Google Scholar
Laibson, D. (1998) Life-cycle consumption and hyperbolic discount functions. European Economic Review, 42(3): 861–871.Google Scholar
Laibson, D., Repetto, A. and Tobacman, J. (2003) A debt puzzle. In Aghion, Philippe, Frydman, Roman, Stiglitz, Joseph, and Woodford, Michael (eds), Knowledge, Information, and Expectations in Modern Economics: In Honor of Edmund S. Phelps. Princeton: Princeton University Press, pp. 228–266.Google Scholar
Laibson, D. I., Repetto, A. and Tobacman, J. (1998) Self-control and saving for retirement. Brookings Papers on Economic Activity, 1998(1): 91–196.Google Scholar
Love, D. A. (2010) The effects of marital status and children on savings and portfolio choice. Review of Financial Studies, 23(1): 385–432.Google Scholar
Love, D. A. (2013) Optimal rules of thumb for consumption and portfolio choice. Economic Journal, 123: 932–961.Google Scholar
Lusardi, A., Michaud, P.-C. and Mitchell, O. S. (2013). Optimal financial knowledge and wealth inequality. Tech. Rep., National Bureau of Economic Research.Google Scholar
Lusardi, A. and Mitchell, O. S. (2011 a) Financial literacy and planning: implications for retirement wellbeing. Tech. Rep., National Bureau of Economic Research.Google Scholar
Lusardi, A. and Mitchell, O. S. (2011 b) Financial literacy and retirement planning in the United States. Journal of Pension Economics and Finance, 10(4): 509–525.Google Scholar
Lusardi, A. and Mitchell, O. S. (2011 c) Financial literacy around the world: an overview. Journal of Pension Economics and Finance, 10(4): 497–508.Google Scholar
Lusardi, A. and Mitchell, O. S. (2014) The economic importance of financial literacy: theory and evidence. Journal of Economic Literature, 52(1): 5–44.Google Scholar
Lusardi, A., Mitchell, O. S. and Curto, V. (2010) Financial literacy among the young. Journal of Consumer Affairs, 44(2): 358–380.Google Scholar
Lusardi, A., Mitchell, O. S. and Curto, V. (2014) Financial literacy and financial sophistication in the older population. Journal of Pension Economics and Finance, 13: 347–366.Google Scholar
Palacios-Huerta, I. and Pérez-Kakabadse, A. (2013) Consumption and Portfolio Rules with Stochastic Hyperbolic Discounting. Departamento de Fundamentos del Análisis Económico I, UPV = Ekonomi Analisiaren Oinarriak I Saila, EHU.Google Scholar
Polkovnichenko, V. (2007) Life-cycle portfolio choice with additive habit formation preferences and uninsurable labor income risk. Review of Financial Studies, 20(1): 83–124.Google Scholar
Spataro, L. and Corsini, L. (2013) Endogenous financial literacy, saving and stock market participation. MPRA Working Paper, 44342.Google Scholar
Van Rooij, M., Lusardi, A. and Alessie, R. (2011). Financial literacy and stock market participation. Journal of Financial Economics, 101(2): 449–472.Google Scholar
Viceira, L. M. (2001) Optimal portfolio choice for long-horizon investors with nontradable labor income. Journal of Finance, 56(2): 433–470.Google Scholar
Vissing-Jorgensen, A. (2002) Towards an explanation of household portfolio choice heterogeneity: nonfinancial income and participation cost structures. NBER Working Paper, No. 8884.Google Scholar
Wachter, J. A. and Yogo, M. (2010) Why do household portfolio shares rise in wealth? Review of Financial Studies, 23(11): 3929–3965.Google Scholar
Yao, R. and Zhang, H. H. (2005) Optimal consumption and portfolio choices with risky housing and borrowing constraints. Review of Financial Studies, 18(1): 197–239.Google Scholar
Yoong, J. (2011) Financial illiteracy and stock market participation: evidence from the RAND American Life Panel. In Olivia S. Mitchell and Annamaria Lusardi (eds). Financial Literacy: Implications for Retirement Security and the Financial Marketplace. Oxford: Oxford University Press, pp. 76–97.Google Scholar
Zeldes, S. P. (1989) Optimal consumption with stochastic income: deviations from certainty equivalence. Quarterly Journal of Economics, 104(2): 275–298.Google Scholar