Behavioral Determinants of Household Financial Decisions

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The existing evidence on economic literacy among the general population casts serious doubt on the proposition that personal financial planning is the consequence of highly sophisticated deliberation, as envisioned in modern economic theory. Much of the population is ill-equipped to make even the most basic economic calculations, and few have mastered more advanced concepts such as compound interest, risk-return tradeoffs, inflation adjustments, or the difference between actual and actuarially fair insurance premiums, that govern the tradeoffs at the heart of the life cycle allocation problem. Although it is conceivable that unsophisticated individuals could act as if they make reasonably well-informed decisions, this is unlikely in the context of personal financial planning. Thus, the study of economic literacy, relevant developmental experiences, and sources of financial information and advice should shed considerable light on household financial decision making, and should aid in the design of public policies that are designed to influence these decisions. This research consists of three parts. Part 1 involves an analysis of data from a new and unique household survey on demographics, developmental experiences, sources of financial information/advice, economic knowledge, and current financial behavior. Data are analyzed to identify and quantify the determinants of developmental experiences, information sources, knowledge, and financial decisions. Part 2 involves the design and preliminary analysis of a follow-on survey. Part 3, which is joint with Jonathan Skinner of the University of Virginia, involves an empirical analysis of economic vulnerabilities, using the Panel Study of Income Dynamics. In particular, the study examines the relationship between consumption trajectories, before and after retirement, and accumulated wealth, in order to test the hypothesis that the observed decline in consumption after retirement reflects farsighted planning, against the view that this decline res ults from inadequate saving.