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Does Everyone Use Probabilities? Intuitive and Rational Decisions about Stockholding

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  • Binswanger, Johannes

    ()
    (Tilburg University)

  • Salm, Martin

    ()
    (Tilburg University)

Abstract

We investigate the relationship between subjective probabilities of future stock market returns and decisions about stockholding. Specifically, we examine whether acting upon subjective probabilities is confined to individuals with high cognitive skills. We explore this question using data from the U.S. Health and Retirement Study (HRS). Our empirical analysis is guided by a novel and simple model based on the dual-systems framework from psychology (Kahneman, 2003). In our model, individuals with low cognitive skills make decisions in an intuitive non-probabilistic way based on cues and feelings. Individuals with high cognitive skills make decisions akin to the expected utility model. As predicted by our model, in our empirical analysis we find that there is a significantly stronger association between subjective return probabilities and stockholding decisions for individuals with high cognitive skills, compared to individuals with lower cognitive skills. The paper contributes to a better understanding of the role of cognitive skills in decision making under uncertainty.

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Bibliographic Info

Paper provided by Institute for the Study of Labor (IZA) in its series IZA Discussion Papers with number 7265.

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Length: 45 pages
Date of creation: Mar 2013
Date of revision:
Handle: RePEc:iza:izadps:dp7265

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Related research

Keywords: subjective expectations; probabilities; dual system decision making; cognitive skills; cognitive economics;

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  1. Fang, H. & Keane, M. & Khwaja, A. & Salm, M. & Silverman, D., 2007. "Testing the mechanisms of structural models: The case of the Mickey Mantle effect," Open Access publications from Tilburg University urn:nbn:nl:ui:12-3160131, Tilburg University.
  2. John J. McArdle & James P. Smith & Robert Willis, 2011. "Cognition and Economic Outcomes in the Health and Retirement Survey," NBER Chapters, in: Explorations in the Economics of Aging, pages 209-233 National Bureau of Economic Research, Inc.
  3. Martin Salm, 2010. "Subjective mortality expectations and consumption and saving behaviours among the elderly," Canadian Journal of Economics, Canadian Economics Association, vol. 43(3), pages 1040-1057, August.
  4. Gomes, Francisco J & Michaelides, Alexander, 2005. "Optimal Life-Cycle Asset Allocation: Understanding the Empirical Evidence," CEPR Discussion Papers 4853, C.E.P.R. Discussion Papers.
  5. Michael D. Hurd, 2009. "Subjective Probabilities in Household Surveys," Annual Review of Economics, Annual Reviews, vol. 1(1), pages 543-564, 05.
  6. Fabian Gouret & Guillaume Hollard, 2011. "When Kahneman meets Manski: Using dual systems of reasoning to interpret subjective expectations of equity returns," Journal of Applied Econometrics, John Wiley & Sons, Ltd., vol. 26(3), pages 371-392, 04.
  7. Barsky, Robert B, et al, 1997. "Preference Parameters and Behavioral Heterogeneity: An Experimental Approach in the Health and Retirement Study," The Quarterly Journal of Economics, MIT Press, vol. 112(2), pages 537-79, May.
  8. Li Gan & Guan Gong & Michael Hurd & Daniel McFadden, 2004. "Subjective Mortality Risk and Bequests," NBER Working Papers 10789, National Bureau of Economic Research, Inc.
  9. Arie Kapteyn & Kristin J. Kleinjans & Arthur Van Soest, 2007. "Intertemporal Consumption with Directly Measured Welfare Functions and Subjective Expectations," Working Papers 535, RAND Corporation Publications Department.
  10. Carman, Katherine Grace & Kooreman, Peter, 2011. "Flu Shots, Mammograms, and the Perception of Probabilities," IZA Discussion Papers 5739, Institute for the Study of Labor (IZA).
  11. Miles S. Kimball & Claudia R. Sahm & Matthew D. Shapiro, 2007. "Imputing Risk Tolerance from Survey Responses," NBER Working Papers 13337, National Bureau of Economic Research, Inc.
  12. Gábor Kézdi & Robert J. Willis, 2011. "Household Stock Market Beliefs and Learning," NBER Working Papers 17614, National Bureau of Economic Research, Inc.
  13. Adeline Delavande & Michael Perry & Robert Willis, 2006. "Probabilistic Thinking and Early Social Security Claiming," Working Papers wp129, University of Michigan, Michigan Retirement Research Center.
  14. Daniel Kahneman, 2003. "Maps of Bounded Rationality: Psychology for Behavioral Economics," American Economic Review, American Economic Association, vol. 93(5), pages 1449-1475, December.
  15. Alexander Michaelides & Francisco J. Gomes, 2005. "Optimal life cycle asset allocation : understanding the empirical evidence," LSE Research Online Documents on Economics 193, London School of Economics and Political Science, LSE Library.
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