Overconfidence in Financial Markets and Consumption Over the Life Cycle

27 Pages Posted: 7 Feb 2007

See all articles by Frank Caliendo

Frank Caliendo

Utah State University

Kevin X. D. Huang

Federal Reserve Bank of Philadelphia; Vanderbilt University - College of Arts and Science - Department of Economics

Date Written: 2007

Abstract

Overconfidence is a widely documented phenomenon. Empirical evidence reveal two types of overconfidence in financial markets: investors both overestimate the average rate of return to their assets and underestimate uncertainty associated with the return. This paper explores implications of overconfidence in financial markets for consumption over the life cycle. The authors obtain a closed-form solution to the time-inconsistent problem facing an overconfident investor/consumer who has a CRRA utility function. They use this solution to show that overestimation of the mean return gives rise to a hump in consumption during the work life if and only if the elasticity of intertemporal substitution in consumption is less than unit. They find that underestimation of uncertainty has little effect on the long-run average behavior of consumption over the work life. Their calibrated model produces a hump-shaped work-life consumption profile with both the age and the amplitude of peak consumption consistent with empirical observations

Keywords: Overconfidence in financial markets, Elasticity of intertemporal substitution, Consumption over the life cycle, Time inconsistency, Hump shape

JEL Classification: D91, E21

Suggested Citation

Caliendo, Frank and Huang, Kevin X. D., Overconfidence in Financial Markets and Consumption Over the Life Cycle (2007). FRB of Philadelphia Working Paper No. 07-3. Available at SSRN: https://ssrn.com/abstract=961367 or http://dx.doi.org/10.2139/ssrn.961367

Frank Caliendo (Contact Author)

Utah State University ( email )

Logan, UT 84322
United States

Kevin X. D. Huang

Federal Reserve Bank of Philadelphia ( email )

Ten Independence Mall
Philadelphia, PA 19106-1574
United States

Vanderbilt University - College of Arts and Science - Department of Economics ( email )

Box 1819 Station B
Nashville, TN 37235
United States

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