Complexity and Sophistication

34 Pages Posted: 9 Jul 2019 Last revised: 22 Aug 2022

See all articles by Leandro Carvalho

Leandro Carvalho

Center for Economic and Social Research (CESR); University of Southern California - Department of Economics

Dan Silverman

Arizona State University (ASU) - W.P. Carey School of Business

Date Written: July 2019

Abstract

Many financial situations present individuals with simple alternatives to solving complex problems. The value of these alternatives depends on whether individuals are sophisticated and know when they are better off opting out of complexity. We tested complexity’s effects and evaluated sophistication in a large and diverse sample. We randomly assigned both complexity to portfolio problems and the offer of a simple alternative to portfolio choice. The less-skilled earn lower returns under complexity because they often opt out when the simple alternative is dominated. To interpret the findings, we develop a novel method for estimating the structural parameters of a rational inattention model. The structural estimates are consistent with substantial sophistication. Large fractions of the money that the low-skilled lose by opting out can be justified by their higher costs of attention.

Suggested Citation

Carvalho, Leandro and Silverman, Dan, Complexity and Sophistication (July 2019). NBER Working Paper No. w26036, Available at SSRN: https://ssrn.com/abstract=3416339

Leandro Carvalho (Contact Author)

Center for Economic and Social Research (CESR) ( email )

635 Downey Way
Los Angeles, CA 90089-3332
United States

University of Southern California - Department of Economics ( email )

3620 South Vermont Ave. Kaprielian (KAP) Hall, 300
Los Angeles, CA 90089
United States

Dan Silverman

Arizona State University (ASU) - W.P. Carey School of Business ( email )

Tempe, AZ 85287-3706
United States

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