Cognitive Abilities and Household Financial Decision Making

42 Pages Posted: 2 Aug 2010 Last revised: 30 Mar 2011

Sumit Agarwal

Georgetown University - Department of Finance

Bhashkar Mazumder

Federal Reserve Bank of Chicago

Date Written: November 23, 2010

Abstract

We analyze the effects of cognitive abilities on two examples of consumer financial decisions where suboptimal behavior is well defined. The first example refers to consumers who transfer the entire balance from an existing credit card account to a new account, but use the new card for convenience transactions, resulting in higher interest charges. The second example refers to consumers who face higher APRs because they inaccurately estimate their property value on a home equity loan or line of credit application. We match individuals from the US military for whom we have detailed test scores from the Armed Services Vocational Aptitude Battery test (ASVAB), to administrative datasets of retail credit from a large financial institution. We show that our matched samples are reasonably representative of the universes from which they are drawn. We find that consumers with higher overall composite test scores, and specifically those with higher math scores, are substantially less likely to make a financial mistake later in life. These mistakes are generally not associated with the non-mathematical component scores. We also conduct some complementary analyses using two other data sources. We use the National Longitudinal Survey of Youth (NLSY) to show that higher ASVAB math scores are associated with lower subjective discount rates. Finally, we use the Health and Retirement Survey (HRS) to demonstrate that particular forms of cognitive ability matter for specific types of suboptimal behavior. We find that the mathematical component of the test is what matters most for financial decision making and financial wealth. In contrast, non-mathematical aptitudes appear to matter for non-financial forms of suboptimal behavior (e.g. failure to take medicine). The HRS results also demonstrate the large ramifications of low math ability on long-term economic success.

Keywords: Household finance, Credit Cards, Home Equity, AFQT Scores

JEL Classification: D1, D4, G2, D8

Suggested Citation

Agarwal, Sumit and Mazumder, Bhashkar, Cognitive Abilities and Household Financial Decision Making (November 23, 2010). FRB of Chicago Working Paper No. 2010-16. Available at SSRN: https://ssrn.com/abstract=1651312

Sumit Agarwal (Contact Author)

Georgetown University - Department of Finance ( email )

3700 O Street, NW
Washington, DC 20057
United States
202-687-8207 (Phone)

HOME PAGE: http://www.ushakrisna.com

Bhashkar Mazumder

Federal Reserve Bank of Chicago ( email )

230 South LaSalle Street
Chicago, IL 60604
United States

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