Overconfidence in financial markets and consumption over the life cycle

Frank Caliendo and Kevin Huang ()

No 07-3, Working Papers from Federal Reserve Bank of Philadelphia

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: Consumption (Economics); Financial markets (search for similar items in EconPapers)
Date: 2007
New Economics Papers: this item is included in nep-cbe, nep-dge, nep-mac and nep-upt
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (4)

Downloads: (external link)
https://www.philadelphiafed.org/-/media/frbp/asset ... pers/2007/wp07-3.pdf (application/pdf)

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:fip:fedpwp:07-3

Ordering information: This working paper can be ordered from

Access Statistics for this paper

More papers in Working Papers from Federal Reserve Bank of Philadelphia Contact information at EDIRC.
Bibliographic data for series maintained by Beth Paul ().