Rules of Thumb in Life-Cycle Saving Decisions

Winter, Joachim ; Schlafmann, Kathrin und Rodepeter, Ralf (October 2011): Rules of Thumb in Life-Cycle Saving Decisions. Discussion Papers in Economics 2011-16

Abstract

We analyse life-cycle saving decisions when households use simple heuristics, or rules of thumb, rather than solve the underlying intertemporal optimization problem. We simulate life-cycle saving decisions using three simple rules and compute utility losses relative to the solution of the optimization problem. Our simulations suggest that utility losses induced by following simple decision rules are relatively low. Moreover, the two main saving motives re ected by the canonical life-cycle model { long-run consumption smoothing and short-run insurance against income shocks { can be addressed quite well by saving rules that do not require computationally demanding tasks such as backward induction.

• Item Type: Paper
• Form of publication: Preprint
• Keywords: saving, life-cycle models, bounded rationality, rules of thumb
• Faculties: Economics; Economics > Munich Discussion Papers in Economics; Economics > Chairs > Chair of Empirical Economics
• Subjects: 300 Social sciences > 300 Social sciences, sociology and anthropology; 300 Social sciences > 330 Economics
• JEL Classification: D91, E21
• Language: English

References

Anderhub, V., W. Güth, W. Müller, and M. Strobel (2000): An experimental analysis of intertemporal allocation behavior. Experimental Economics, 3, 137{152.

Attanasio, O. P. and G. Weber (2010): Consumption and saving: Models of intertemporal allocation and their implications for public policy. Journal of Economic Literature, 48, 693-751.

Binswanger, J. and K. G. Carman (2011): How real people make long-term decisions: The case of retirement preparation. Unpublished manuscript, Tilburg University.

Blundell, R., L. Pistaferri, and I. Preston (2008): Consumption inequality and partial insurance. American Economic Review, 98, 1887-1921.

Brown, A. L., Z. E. Chua, and C. F. Camerer (2009): Learning and visceral temptation in dynamic saving experiments. Quarterly Journal of Economics, 124, 197-231.

Browning, M. and T. F. Crossley (2001): The life-cycle model of consumption and saving. Journal of Economic Perspectives, 15(3), 3-22.

Browning, M. and A. Lusardi (1996): Household saving: Micro theories and micro facts. Journal of Economic Literature, 34, 1797-1855.

Cagetti, M. (2003): Wealth accumulation over the life cycle and precautionary savings. Journal of Business and Economic Statistics, 21, 339-353.

Calvet, L. E., J. Y. Campbell, and P. Sodini (2007): Down or out: Assessing the welfare costs of household investment mistakes. Journal of Political Economy, 115, 707-747.

Camerer, C. (1995): Individual decision making. In J. H. Kagel and A. E. Roth (Eds.), Handbook of Experimental Economics, 587-703. Princeton, NJ: Princeton University Press.

Campbell, J. Y. and G. N. Mankiw (1990): Permanent income, current income, and consumption. Journal of Business and Economic Statistics, 8, 265-279.

Carbone, E. and J. D. Hey (1999): A test of the principle of optimality. Theory and Decision, 50, 263-281.

Carroll, C. D. (1992): The buer stock theory of saving: Some macroeconomic evidence. Brookings Papers on Economic Activity, No. 2, 61-135.

Carroll, C. D. (1997): Buer-stock saving and the life cycle-permanent income hypothesis. Quarterly Journal of Economics, 112, 1-55.

Choi, J. J., D. Laibson, B. C. Madrian, and A. Metrick (2005): Passive decisions and potent defaults. In D. A. Wise (Ed.), Analyses in the Economics of Aging, 59-78. Chicago and London: Cambridge University Press.

Cocco, J. F., F. J. Gomes, and P. J. Maenhout (2005): Consumption and portfolio choice over the life cycle. Review of Financial Studies, 18, 491-533.

Cochrane, J. H. (1989): The sensitivity of tests of the intertemporal allocation of consumption to near-rational alternatives. American Economic Review, 79, 319-337.

Conlisk, J. (1996): Why bounded rationality? Journal of Economic Literature, 34, 669-700.

Deaton, A. (1991): Saving and liquidity constraints. Econometrica, 59(5), 1221-1248.

Deaton, A. (1992a): Household saving in LDCs: Credit markets, insurance and welfare. Scandinavian Journal of Economics, 94, 253-273.

Deaton, A. (1992b): Understanding Consumption. Oxford, UK: Clarendon Press.

Drexler, A., G. Fischer, and A. Schoar (2010): Keeping it simple: Financial literacy and rules of thumb. Discussion Paper No. 7994, CEPR, London.

Flavin, M. A. (1981): The adjustment of consumption to changing expectations about future income. Journal of Political Economy, 89, 974-1009.

Friedman, M. (1957): A Theory of the Consumption Function. Princeton, NJ: Princeton University Press.

Gigerenzer, G. and P. M. Todd (1999): Fast and frugal heuristics. In G. Gigerenzer, P. M. Todd, and the ABC Research Group (Eds.), Simple Heuristics That Make Us Smart, 3-34. New York, NY and Oxford, UK: Oxford University Press.

Goodie, A. S., A. Ortmann, J. N. Davis, S. Bullock, and G. M. Werner (1999): Demons versus heuristics in articial intelligence, behavioral ecology, and economics. In G. Gigerenzer, P. M. Todd, and the ABC Research Group (Eds.), Simple Heuristics That Make Us Smart, 327-355. New York, NY and Oxford, UK: Oxford University Press.

Gourinchas, P.-O. and J. A. Parker (2002): Consumption over the life cycle. Econometrica, 70, 47-89.

Hall, R. E. (1978): Stochastic implications of the life cycle-permanent income hypothesis: Theory and evidence. Journal of Political Economy, 86, 971-987.

Hall, R. E. and F. Mishkin (1982): The sensitivity of consumption to transitory income: Estimates from panel data on households. Econometrica, 50, 461-481.

Hey, J. D. (2005): Do people (want to) plan? Scottish Journal of Political Economy, 52, 122-138.

Hey, J. D. and V. Dardanoni (1988): Optimal consumption under uncertainty: An experimental investigation. Economic Journal, 98, S105-S116.

Hey, J. D. and J. A. Knoll (2010): Strategies in dynamic decision making: An experimental investigation of the rationality of decision behaviour. Unpublished manuscript, University of York.

Hey, J. D. and G. Lotito (2009): Naive, resolute or sophisticated? A study of dynamic decision making. Journal of Risk and Uncertainty, 38, 1-25.

Hey, J. D. and L. Panaccione (2011): Dynamic decision making: What do people do? Journal of Risk and Uncertainty, 42, 85-123.

Hindy, A., C. H. and S. H. Zhu (1997): Optimal consumption and portfolio rules with durability and habit formation. Journal of Economic Dynamics and Control, 21, 525-550.

Houser, D. and J. Winter (2004): How do behavioral assumptions aect structural inference? Evidence from a laboratory experiment. Journal of Business and Economic Statistics, 22, 64-79.

Johnson, S., L. J. Kotliko, and W. Samuelson (2001): Can people compute: An experimental test of the life-cycle consumption model. In L. C. Kotliko (Ed.), Essays on Saving, Bequests, Altruism, and Life-Cycle Planning, 335-385. Cambridge, MA, and London, UK: MIT Press (first circulated in March 1987 as NBER Working Paper No. 2183).

Keynes, J. M. (1936): The General Theory of Employment, Interest and Money. London: Macmillan.

Krueger, D. and A. Ludwig (2007): On the consequences of demographic change for rates of returns to capital, and the distribution of wealth and welfare. Journal of Monetary Economics, 54, 49-87.

Laibson, D. (1998): Life-cycle consumption and hyperbolic discount functions. European Economic Review, 42(3-5), 861-871.

Lettau, M. and H. Uhlig (1999): Rules of thumb versus dynamic programming. American Economic Review, 89, 148-174.

Loewenstein, G. (1992): The fall and rise of psychological explanation in the economics of intertemporal choice. In G. Loewenstein and J. Elster (Eds.), Choice Over Time. New York: Russell Sage Foundation.

Low, H., C. Meghir, and L. Pistaferri (2010): Wage risk and employment risk over the life cycle. American Economic Review, 100, 1432-1467.

Lusardi, A. and O. S. Mitchell (2007): Baby boomer retirement security: The roles of planning, nancial literacy, and housing wealth. Journal of Monetary Economics, 54, 205-224.

Moon, P. and A. Martin (1990): Better heuristics for economic search: Experimental and simulation evidence. Journal of Behavioral Decision Making, 3, 177-193.

Müller, W. (2001): Strategies, heuristics, and the relevance of risk-aversion in a dynamic decision problem. Journal of Economic Psychology, 22, 493-522.

Pemberton, J. (1993): Attainable non-optimality or unattainable optimality: A new approach to stochastic life cycle problems. Economic Journal, 103, 1-20.

Rabin, M. (1998): Psychology and economics. Journal of Economic Literature, 36, 11-46.

Rodepeter, R. and J. Winter (1998): Saving decisions under life-time and earnings uncertainty: Empirical evidence from West German household data. Discussion Paper No. 98-58, Sonderforschungsbereich 504, Universität Mannheim.

Rodepeter, R. and J. Winter (1999): Rules of thumb in life-cycle saving decisions. Discussion Paper No. 99-81, Sonderforschungsbereich 504, Universität Mannheim.

Sauter, N. and J. Winter (2010): Do investors respond to tax reform? Evidence from a natural experiment in Germany. Economics Letters, 108, 193-196.

Scholz, J. K., A. Seshadri, and S. Khitatrakun (2006): Are Americans saving \optimally" for retirement? Journal of Political Economy, 114, 607-643.

Shefrin, H. M. and R. H. Thaler (1988): The behavioral life-cycle hypothesis. Economic Inquiry, 26, 609-643.

Shi, S. and L. G. Epstein (1993): Habits and time preference. International Economic Review, 34, 61-84.

Simon, H. A. (1955): A behavioral model of rational choice. Quarterly Journal of Economics, 69, 99-118.

Thaler, R. H. (1994): Psychology and savings policies. American Economic Review, Papers & Proceedings, 84(2), 186-192.

Thaler, R. H. and S. Benartzi (2004): Save more tomorrow: Using behavioral economics to increase employee saving. Journal of Political Economy, 112, S164-S187.

van Rooij, M. C. J., A. Lusardi, and R. Alessie (2011): Financial literacy and stock market participation. Journal of Financial Economics, 101, 449-472.

Wärneryd, K.-E. (1989): On the psychology of saving: An essay on economic behavior. Journal of Economic Psychology, 10, 515-541.

Weber, C. E. (2000): Rule-of-thumb consumption, intertemporal substitution, and risk aversion. Journal of Business and Economic Statistics, 18(4), 497-502.

Weber, C. E. (2002): Intertemporal non-separability and \rule-of-thumb" consumption. Journal of Monetary Economics, 49, 293-308.