Present-Bias and the Value of Sophistication

Abstract

This paper develops a dynamic wealth management model for risk-averse investors displaying present-bias in the form of hyperbolic discounting. The investor chooses an optimal consumption policy and allocates her funds between a risk-free asset, a traded liquid asset, and a non-traded illiquid asset. We characterize these policies for both sophisticated and naive present-biased investors. There are three results. First, sophisticated investors over-consume more than their naive counterparts if and only if their coefficient of relative risk-aversion is smaller than one. As a result, sophistication is welfare reducing (increasing) when risk-aversion is low (high). Second, increasing asset illiquidity always benefits the sophisticated investor more than the naive investor. Thus, the welfare gap between sophisticated and naive investors is increasing in the proxy for asset illiquidity. Finally, present-biased investors accumulate a larger share of their wealth in the non-traded illiquid asset than in the traded risky stock compared to the neoclassical exponential discounter investor. As a consequence, from the perspective of present-biased investors, the equity premium puzzle (1985) and the private equity puzzle (2002) are two sides of the same coin.

Keywords: Present-Bias, Behavioral Finance, Private Equity Puzzle, Commitment Devices.

JEL Classification: G02, G11, D21