Hyperbolic Discounting and Life-Cycle Portfolio Choice

David Love and Gregory Phelan

No 2015-11, Department of Economics Working Papers from Department of Economics, Williams College

Abstract: This paper studies how hyperbolic discounting affects stock market participation, asset allocation, and saving decisions over the life cycle in an economy with Epstein-Zin preferences. Hyperbolic discounting affects saving and portfolio decisions through at least two channels: (1) it lowers desired saving, which decreases financial wealth relative to future earnings; and (2) it lowers the incentive to pay a fixed cost to enter the stock market. We find that hyperbolic discounters accumulate less wealth relative to their geometric counterparts and that they participate in the stock market at a later age. Because they have lower levels of financial wealth relative to future earnings, hyperbolic discounters who do participate in the stock market tend to hold a higher share of equities, particularly in the retirement years. We find that increasing the elasticity of intertemporal substitution, holding risk aversion constant, greatly magnifies the impact of hyperbolic discounting on all of the model's decision rules and simulated levels of participation, allocation, and wealth. Finally, we introduce endogenous financial knowledge accumulation and find that hyperbolic discounting leads to lower financial literacy and inefficient stock market investment.

Keywords: Hyperbolic discounting; Epstein-Zin; portfolio choice; financial literacy (search for similar items in EconPapers)
JEL-codes: D91 E21 G11 G22 (search for similar items in EconPapers)
Pages: 48 pages
Date: 2015-07
New Economics Papers: this item is included in nep-age, nep-dge and nep-mac
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Forthcoming in the Journal of Pension Economics and Finance.

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Journal Article: Hyperbolic discounting and life-cycle portfolio choice* (2015)
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