Misunderestimation: Exponential-Growth Bias and Time-Varying Returns
9 Pages Posted: 15 Jul 2015
Date Written: July 14, 2015
Exponential-growth bias is the tendency to neglect the compounding of interest. The economics literature has used the fact that a biased agent in many circumstances will underestimate the value of assets that grow according to compound interest. We show that the opposite can also be true. It is always possible to make an agent who underestimates exponential growth to overestimate the value of an asset that grows exponentially. This paradoxical phenomenon arises when interest rates vary over time. This gives rise to the averaging effect of exponential-growth bias, which causes agents to perceive the mean return to exceed the true mean. Consequently, biased agents will strictly prefer assets with time-varying returns over equivalent constant-return assets. With sufficient variation in returns, any biased agent will overestimate the true value of an asset for any time horizon.
Keywords: exponential-growth bias, compound interest, averaging effect, extrapolation effect
JEL Classification: D03, D14, D91
Suggested Citation: Suggested Citation