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Hyperbolic discounting and life-cycle portfolio choice*

Published online by Cambridge University Press:  01 October 2015

DAVID LOVE  and
GREGORY PHELAN
DAVID LOVE
Affiliation:
Williams College, Williamstown, MA 01267, USA (e-mail: [email protected], [email protected])
GREGORY PHELAN
Affiliation:
Williams College, Williamstown, MA 01267, USA (e-mail: [email protected], [email protected])
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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

G11G22D91E21Hyperbolic discountingEpstein–Zinportfolio choicefinancial literacy
Type
Articles
Information
Journal of Pension Economics & Finance , Volume 14 , Special Issue 4: Household Finance , October 2015 , pp. 492 - 524
Copyright
Copyright © Cambridge University Press 2015 

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Footnotes

*

We are grateful for the excellent research assistance of Jesse Freeman and Rebecca Lewis.

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