Misunderestimation: Exponential-Growth Bias and Time-Varying Returns

9 Pages Posted: 15 Jul 2015

See all articles by Matthew Levy

Matthew Levy

London School of Economics & Political Science (LSE) - Department of Economics

Joshua Tasoff

Claremont Colleges - Claremont Graduate University

Date Written: July 14, 2015

Abstract

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

Levy, Matthew and Tasoff, Joshua, Misunderestimation: Exponential-Growth Bias and Time-Varying Returns (July 14, 2015). Available at SSRN: https://ssrn.com/abstract=2630864 or http://dx.doi.org/10.2139/ssrn.2630864

Matthew Levy

London School of Economics & Political Science (LSE) - Department of Economics ( email )

Houghton Street
London WC2A 2AE
United Kingdom

Joshua Tasoff (Contact Author)

Claremont Colleges - Claremont Graduate University ( email )

150 E. Tenth Street
Claremont, CA 91711
United States

HOME PAGE: http://sites.cgu.edu/tasoffj/

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