Fuzzy Math and Household Finance Theory and Evidence

Short Description
opportunity cost perceptions can be explained by a parsimonious theory. Our new theory is. based on a mathematical microfoundation from cognitive …

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Fuzzy Math and Household Finance:
Theory and Evidence*
Victor Stango
Tuck School of Business
Dartmouth College
Jonathan Zinman
Department of Economics
Dartmouth College
September 2007
ABSTRACT
Recent work on intertemporal choice has varied the specification of every key aspect
of modeling except the opportunity cost of consumption. We present evidence that
consumers have present-biased perceptions about the opportunity cost of consumption:
they tend to underestimate the cost of short-term borrowing and the return to long-term
saving. We develop a new theory that fits this evidence and is based on a more general
cognitive tendency to underestimate exponential series. The theory predicts that more
biased consumers will save less and hold less wealth, hold more short-term installment
debt and fewer stocks, and use and benefit from financial advice relatively intensively.
The data bear out these predictions and show that an easily measured metric of
opportunity cost misperception correlates with household financial condition in
statistically and economically important ways.
JEL codes: D1, D9, G11
Keywords: household finance, intertemporal choice, portfolio choice, interest rates, exponential
growth bias, psychology and economics, behavioral finance, bounded cognition, financial advice
* Contact: victor.stango@dartmouth.edu, jzinman@dartmouth.edu. Thanks to Jonathan Bauchet…