Overconfidence in Financial Markets and Consumption Over the Life Cycle
27 Pages Posted: 7 Feb 2007
Date Written: 2007
Abstract
Overconfidence is a widely documented phenomenon. Empirical evidence reveal two types of overconfidence in financial markets: investors both overestimate the average rate of return to their assets and underestimate uncertainty associated with the return. This paper explores implications of overconfidence in financial markets for consumption over the life cycle. The authors obtain a closed-form solution to the time-inconsistent problem facing an overconfident investor/consumer who has a CRRA utility function. They use this solution to show that overestimation of the mean return gives rise to a hump in consumption during the work life if and only if the elasticity of intertemporal substitution in consumption is less than unit. They find that underestimation of uncertainty has little effect on the long-run average behavior of consumption over the work life. Their calibrated model produces a hump-shaped work-life consumption profile with both the age and the amplitude of peak consumption consistent with empirical observations
Keywords: Overconfidence in financial markets, Elasticity of intertemporal substitution, Consumption over the life cycle, Time inconsistency, Hump shape
JEL Classification: D91, E21
Suggested Citation: Suggested Citation
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