Households are Irrational (Double Review)
What’s Up in Economics
By Joe Maginnis
In an American Economic Review that lacked striking insights, one theme came up several times: that households are irrational or, alternatively, people are dumb. Classical economics is a handy tool for describing the behavior of a rational actor under a certain set of incentives. Naturally, we must make some assumptions about what is rational versus what is not, but this is surprisingly easy to do in most cases. Despite the obviousness of some of these assumptions, there are many cases where people contradict what classical economics would predict. On one hand, it’s hard to imagine people would ever act perfectly rationally all the time – we are not robots that are constantly optimizing. On the other hand, some examples of irrational behavior are downright comical – but more than that, they reveal important information about human behavior.
Article 1: Does Household Finance Matter? Small Financial Errors with Large Social Costs
The authors build on previous findings from standard portfolio theory – that it is better to hold diversified portfolios of assets all else equal – along with evidence that households tend to hold under-diversified assets to investigate the question: how does under-diversification of household finances impact real investment, social welfare, and aggregate growth in a dynamic, general equilibrium, production economy? Though the authors do not directly study the different ways households under-diversify, they do reference prior research on the topic, and some of the examples of familiarity bias are too comical to ignore (however, I am no exception to them). For example: individuals in the United States tend to hold the stock of their local telephone company; they tend to hold the stock of the company with which they are employed; and they tend to invest heavily in “home equity” rather than diversifying internationally. Remind you of someone?
Instead of studying their root cause, the authors study the welfare implications of these inefficiencies in order to support some questionable financial policies. They find that, even though the household is only penalized by 1% on its portfolio returns at a given risk level from under-diversification, that loss increases by a factor of 5 in aggregate when considering a general equilibrium instead of a partial equilibrium. That’s because despite familiarity biases canceling out in aggregate – Jim from Pittsburg owns AT&T’s stock and Joe from Philly owns Verizon’s stock, so there is diversification in aggregate – there is under-allocation due to excessive risk taking, which does not cancel out in aggregate – Joe and
Jim both under-invest in their assets compared to a scenario where they are both diversified – so there is less overall investment in the economy. The results suggest that a solution to under-diversification could improve aggregate growth by a whopping 5%.
GENERAL VS. PARTIAL EQUILIBRIUM (Definition)
General equilibrium refers to the balancing of supply and demand of all goods and services throughout the whole economy, while partial equilibrium only considers supply and demand of some goods and services in a part of the whole economy.
Though I am directionally convinced by the findings of the paper (5% seems a bit high), I am not supportive of the regulatory suggestions made by the authors as a way to correct the under-diversification. They are: 1) to introduce “default portfolios” whereby investors must opt out of a diversified option before selecting an asset that is more risky, 2) to offer education about the benefits of diversification, and 3) to introduce financial regulations that restrict the amount of idiosyncratic risk in a household’s portfolio. Let’s let the financial software companies deal with this one, guys. With the rise of passive investing in mutual funds and ETFs, I’m confident that the problem of under-diversification is getting better and will continue to do so in the future absent of policy intervention.
Article 2: How Do Individuals Repay Their Debt? The Balance-Matching Heuristic
The authors use linked data on people in the UK with multiple credit cards to analyze debt repayment behavior (or should I say behaviour), and their findings shed light into the mind of the human animal. Importantly, the authors only focused on individuals with exactly two credit cards. The average difference in rates between the high and low Average Percentage Rate (APR) cards was 6.3 percentage points – roughly one third of the average 19.7% APR in the sample. They point out that the decision about which card to repay is an ideal experiment because optimal behavior – to repay the high interest rate card first – can be clearly defined. The authors first show that individuals allocate only 51.5% of their excess payments to the high APR card – behavior that cannot be distinguished from complete unresponsiveness to interest rates. Then, they test the result across all APR disparities and find that, even in the case of a 15+ percentage point disparity between high and low, individuals are completely unresponsive to interest rate incentives (keep in mind that these results happened in a financially literate country). After reviewing several cognitive heuristics that might be at play, the authors found that over half of the predictable variation in repayment behavior could be explained by balance matching: where the balance paid to each card is proportional to the existing balance on the card.
