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Cognitive abilities and household financial decision making

Author

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  • Sumit Agarwal
  • Bhashkar Mazumder

Abstract

We analyze the effects of cognitive abilities on two examples of consumer financial decisions where suboptimal behavior is well defined. The first example refers to consumers who transfer the entire balance from an existing credit card account to a new account, but use the new card for convenience transactions, resulting in higher interest charges. The second example refers to consumers who face higher APRs because they inaccurately estimate their property value on a home equity loan or line of credit application. We match individuals from the US military for whom we have detailed test scores from the Armed Services Vocational Aptitude Battery test (ASVAB), to administrative datasets of retail credit from a large financial institution. We show that our matched samples are reasonably representative of the universes from which they are drawn. We find that consumers with higher overall composite test scores, and specifically those with higher math scores, are substantially less likely to make a financial mistake later in life. ; These mistakes are generally not associated with the non-mathematical component scores. We also conduct some complementary analyses using two other data sources. We use the National Longitudinal Survey of Youth (NLSY) to show that higher ASVAB math scores are associated with lower subjective discount rates. Finally, we use the Health and Retirement Survey (HRS) to demonstrate that particular forms of cognitive ability matter for specific types of suboptimal behavior. We find that the mathematical component of the test is what matters most for financial decision making and financial wealth. In contrast, non-mathematical aptitudes appear to matter for non-financial forms of suboptimal behavior (e.g. failure to take medicine). The HRS results also demonstrate the large ramifications of low math ability on long-term economic success.

Suggested Citation

  • Sumit Agarwal & Bhashkar Mazumder, 2011. "Cognitive abilities and household financial decision making," Working Paper Series WP-2010-16, Federal Reserve Bank of Chicago.
  • Handle: RePEc:fip:fedhwp:wp-2010-16
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    References listed on IDEAS

    as
    1. Xavier Gabaix & David Laibson, 2006. "Shrouded Attributes, Consumer Myopia, and Information Suppression in Competitive Markets," The Quarterly Journal of Economics, Oxford University Press, pages 505-540.
    2. Daniel J. Benjamin & Sebastian A. Brown & Jesse M. Shapiro, 2013. "Who Is ‘Behavioral’? Cognitive Ability And Anomalous Preferences," Journal of the European Economic Association, European Economic Association, vol. 11(6), pages 1231-1255, December.
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    More about this item

    Keywords

    Households - Finance ; Consumer behavior;

    JEL classification:

    • D14 - Microeconomics - - Household Behavior - - - Household Saving; Personal Finance
    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages

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