Love Phelan 2015

https://doi.org/10.
1017/S1474747215000220 Published online by Cambridge University Press

PEF, 14 (4): 492–524, October, 2015. © Cambridge University Press 2015 492
doi:10.1017/S1474747215000220
Hyperbolic discounting and life-cycle portfolio

choice*
DAVID LOVE AND GREGORY PHELAN

Williams College, Williamstown, MA 01267, USA
(e-mail: david.love@williams.edu, gregory.phelan@williams.edu)
Abstract
This paper studies how hyperbolic discounting affects stock market participation,
asset allocation, and saving decisions over the life cycle in an economy with Epstein–Zin
preferences. Hyperbolic discounting affects saving and portfolio decisions through at least
two channels: (1) it lowers desired saving, which decreases financial wealth relative to future
earnings; and (2) it lowers the incentive to pay a fixed cost to enter the stock market. We
find that hyperbolic discounters accumulate less wealth relative to their geometric
counterparts and that they participate in the stock market at a later age. Because they have
lower levels of financial wealth relative to future earnings, hyperbolic discounters who do
participate in the stock market tend to hold a higher share of equities, particularly in the
retirement years. We find that increasing the elasticity of intertemporal substitution, holding
risk aversion constant, greatly magnifies the impact of hyperbolic discounting on all of the
model’s decision rules and simulated levels of participation, allocation, and wealth. Finally,
we introduce endogenous financial knowledge accumulation and find that hyperbolic
discounting leads to lower financial literacy and inefficient stock market investment.
JEL CODES: G11, G22, D91, E21
Keywords: Hyperbolic discounting, Epstein–Zin, portfolio choice, financial literacy.
1 Introduction
With the ongoing shift toward defined contribution pensions in many countries,
households now bear an increasing share of responsibility for building up and man-
aging their own retirement savings. In the US, for example, many employees have
to decide whether to participate in their employer plans, how much to contribute if
they do participate, and how to allocate their assets within the plans. These are com-
plex decisions, and there is growing concern that a combination of low financial liter-
acy and behavioral anomalies, such as limited self-control, may expose numerous
households to financial insecurity in retirement.1
* We are grateful for the excellent research assistance of Jesse Freeman and Rebecca Lewis.
1
Lusardi and Mitchell (2014) review the growing literature on financial literacy, much of which draws on
their pioneering introduction of experimental modules in the Health and Retirement Study (see, e.g.,
Lusardi et al., 2010; Lusardi and Mitchell, 2011a, b, c). Frederick et al. (2002)) provides a review of
https://doi.org/10.1017/S1474747215000220 Published online by Cambridge University Press
Hyperbolic discounting and life-cycle portfolio choice 493
We explore how a specific behavioral anomaly – hyperbolic discounting – affects

household decisions about saving, stock market participation, and asset allocation.
While a large literature documents the impact of hyperbolic discounting on household
decisions about saving, much less is known about its importance for portfolio deci-
sions. In the case of portfolio choice, one reason for the limited attention may be
that hyperbolic discounting has been shown to have no effect on optimal allocation
decisions, holding constant the amount of financial wealth (Palacios-Huerta and
Pérez-Kakabadse, 2013). The reason is simple: an investor’s time-preference does
not affect her preference for risk. And while time-preference matters for the saving
decision, it does not alter the optimal allocation of a given amount of savings to
risky assets. If, however, hyperbolic discounting leads to lower saving, hyperbolic dis-
counting may influence portfolio choice over the life cycle in at least two ways.
First, if investors face imperfect credit markets that prohibit borrowing against
human capital, their optimal portfolio allocation will depend on both the current
level of financial wealth and the expected present discounted value of future income.
Since stock market returns are generally much more volatile than future earnings, but
with a low covariance, investors with lower levels of financial wealth will invest a
higher proportion of wealth in risky assets. Hyperbolic discounters may therefore in-
vest more of their wealth in the stock market precisely because they accumulate less of
it. Second, hyperbolic discounting also tends to make investors less willing to pay any
fixed costs associated with participating in the stock market. It may therefore provide
at least a partial explanation for the observed low rates of stock market participation
for the population as a whole, as well as for the observed increase in participation
rates during the working years (Ameriks and Zeldes, 2004; Gomes and
Michaelides, 2005).
In addition, we show that the importance of hyperbolic discounting for saving and
asset allocation depends crucially on the willingness of households to substitute con-
sumption over time. Intuitively, a low willingness intertemporally can push against
the tendency for hyperbolic discounting to reduce saving since these households
would prefer a relatively constant stream of consumption. By the same token, a
high willingness to substitute can magnify the impact of hyperbolic discounting on
saving and allocation decisions. While previous work has studied the impact of risk
aversion on hyperbolic discounting in a Constant Relative Risk Aversion (CRRA)
setup (see Laibson 1997, 1998), there has not been a separate treatment of the elasti-
city of substitution, holding risk aversion constant. One of the main contributions of
our paper is to show that the elasticity of substitution plays a central role in determin-
ing the importance of hyperbolic discounting for saving, allocation, and stock-market
participation decisions.
We develop these insights using a life-cycle model of saving and asset allocation
that builds on the seminal model of Gomes and Michaelides (2005) by introducing
quasi-hyperbolic discounting into a model with Epstein–Zin preferences (Epstein
influential studies modeling time inconsistency and other behavioral anomalies. Angeletos et al. (2001)
discusses some of the earlier applications of hyperbolic discounting to retirement saving, including the
seminal contributions of Laibson (1997, 1998) and Laibson et al. (1998).
494 David Love and Gregory Phelan
and Zin, 1989).2 We find that the elasticity of intertemporal substitution (EIS) ends up
amplifying the impact of hyperbolic discounting on saving and asset allocation deci-
sions. The hyperbolic modification of Epstein–Zin preferences is not only important
for understanding the relationship between present bias and allocation to risky assets;
it also provides a more general framework for studying hyperbolic discounting and
the EIS, including how savings decisions respond to income risk. One of the key
results in the hyperbolic discounting literature, for example, is that hyperbolic dis-
counting increases the demand for illiquid savings (e.g., Laibson et al., 1998). An im-
plication of our results is that the demand for illiquid savings will also be sensitive to
the interaction between hyperbolic discounting and the EIS.
In our model, hyperbolic discount rates lead to lower wealth levels directly through
the modified hyperbolic Euler equation (Harris and Laibson, 2001). All else constant,
lower wealth levels tend to increase the optimal exposure to financial market risk since
future consumption depends relatively more on future human capital and less on
financial wealth. Simulations of the model indicate that hyperbolic discounters invest
a higher proportion of their wealth in stocks – though the dollar value of wealth in
stocks is lower. In fact, hyperbolic discounters are also likely to begin investing in
the stock market later in life because stock market participation requires fixed
setup costs. Hence, our model produces hyperbolic discounters with low levels of
savings, who put off investing in the stock market until late in life but then invest a
high fraction of their wealth in stocks. Furthermore, portfolios in retirement are
heavily invested in the stock market, with stock market exposure increasing with
age. These findings have important policy implications, suggesting that automatic
contributions to savings and retirement accounts may be more important than previ-
ously thought.
Another possibility is that hyperbolic discounting may affect saving decisions
through a knowledge accumulation channel. Financial literacy and behavioral anom-
alies have generally been treated as separate sources of poor decision-making, but it is
reasonable to expect that they may be linked. After all, given that hyperbolic dis-
counting causes households to underinvest in financial capital, it should also induce
suboptimal investment in financial knowledge. To consider this possibility, we extend
the model to include endogenous financial knowledge investment in the spirit of
Jappelli and Padula (2013) and Lusardi et al. (2013) by requiring investors to pay
costs to accumulate knowledge of financial markets and investment opportunities,
which improves the equity premium investors receive on risky assets and reduces
the fixed costs associated with investing in risky assets. In our setup, endogenous
financial literacy provides a channel through which hyperbolic discounting can affect
optimal allocation decisions for a given amount of financial wealth.
2
Laibson (1998) explores some of the implications of hyperbolic discounting on the elasticity of intertem-
poral substitution (EIS) in the case of CRRA preferences. In particular, he shows that when the coeffi-
cient of relative risk aversion is greater than one, the EIS will be less than the reciprocal of risk aversion.
Geraats (2006) builds on Laibson’s insights and shows that the EIS depends, more generally, on the per-
sistence of the intertemporal price change, with elasticities decreasing in the duration of the change. Our
focus is not on hyperbolic discounting’s impact on the EIS, but rather the joint effect of different assump-
tions about discounting and the EIS on life-cycle decisions.
We find that hyperbolic discounters not only save less, but also invest less in
financial knowledge than geometric discounters. The low investment in financial
knowledge reflects both a direct and an indirect effect. The direct effect is that present-
biased savers are simply less willing to spend current resources to improve future
returns. The indirect effect is that because they also accumulate less wealth, they
have less of an incentive to ensure that savings are invested efficiently. Hyperbolic dis-
counting therefore leads to lower wealth, lower returns to financial knowledge, and
less investment in financial knowledge. These, in turn, decrease the returns to savings
and further decrease wealth accumulation. Among other things, this implies that
hyperbolic discounters may be doubly disadvantaged when it comes to saving.
They not only arrive at retirement with lower wealth; they also invest their wealth
less efficiently than their geometric-discounting counterparts. This means that the
high exposure to the stock market in retirement is particularly costly for agents
with low financial literacy.
The remainder of the paper proceeds as follows: Section 2 provides a brief review of
the literature on life-cycle portfolio choice and financial knowledge. Section 3 presents
our model of hyperbolic discounting and portfolio choice. Section 4 discusses the
implications of introducing hyperbolic discounting into Epstein–Zin preferences.
Section 5 introduces financial knowledge investment and presents the simulation
results. And the final section concludes.
2 Literature review
The empirical observation that both literacy and present-bias tend to be associated
with wealth accumulation motivates the introduction of hyperbolic discounting into
the endogenous literacy framework (Hastings and Mitchell, 2011). The seminal con-
tributions of Laibson (1997), Laibson et al. (1998), and Harris and Laibson (2001)3
incorporate hyperbolic discounting into both discrete and continuous time versions
of the standard consumption model. These important contributions have influenced
numerous studies on a range of topics, including saving (including the original stud-
ies), endogenous retirement (Diamond and Köszegi, 2003), economic growth (Barro,
1999), and debt (Laibson et al., 2003). In terms of portfolio choice, an important
finding is that hyperbolic discounting does not directly affect portfolio rules in a
standard power utility setup in continuous time.4
Studies examining life-cycle portfolio choice, however, frequently depart from the
standard power utility setup in order to separately consider the roles of risk aversion
3
Angeletos et al. (2001) provide an excellent summary of the calibrated hyperbolic life-cycle model, as well
as its empirical support.
4
Palacios-Huerta and Pérez-Kakabadse (2013) demonstrate this irrelevance result using a standard
Merton setup where investors have ‘instant gratification’ time-preferences (a continuous time analog
of hyperbolic discounting). They show that an investor’s time-preference matters for the savings decision,
but not for how savings are allocated to risky assets. Technically, the optimality conditions for portfolio
shares are independent of the inter-temporal trade-off. Instant gratification investors allocate wealth less
wealth to savings, but they allocate their savings to risky and safe investments in the same proportions as
‘exponential’ investors.
and the intertemporal elasticity of substitution (EIS).5 One of the most influential
studies in this regard is Gomes and Michaelides (2005), which focuses on the roles
of risk aversion and intertemporal substitution in explaining observed low rates of
stock market participation. Motivated by the observation that more risk-averse
households are more willing to pay fixed costs of stock market participation (since
they have a stronger precautionary savings motive), Gomes and Michaelides (2005)
attempt to explain low participation rates by allowing for preference heterogeneity
along the dimension of risk aversion. This alone, however, does not solve the problem
since less risk averse households in a CRRA setup also have high EIS values, which
induces them to build up more saving as long as the expected return on the portfolio
exceeds the discount rate. With Epstein–Zin preferences, however, Gomes and
Michaelides (2005) are able to assign some households low values of both risk aver-
sion and the EIS, thereby offering a candidate explanation for why some households
choose not to participate in the stock market. In our paper, the EIS exerts a similarly
strong force on the saving decisions of both hyperbolic and geometric discounters, but
in opposite directions: the EIS leads to higher saving and participation rates for
geometric discounters, but lower saving and participation rates for hyperbolic
discounters.
In connecting hyperbolic discounting and financial knowledge, we are building on a
growing body of research seeking to understand the connections between financial
knowledge, cognition, wealth, and portfolio choice.6 One of the key findings in this
literature is that financial literacy tends to be positively correlated with wealth,
and that it follows a similar hump-shaped path over the life cycle, with lower levels
of literacy among the young (Lusardi et al., 2010) and the old (Lusardi et al.,
2014). It is less clear, however, exactly why this pattern emerges. It could reflect a cau-
sal relationship running from financial literacy to decisions affecting the accumulation
and allocation of wealth. But it is also possible that causality runs in the reverse
direction – from wealth to literacy – or that some third variable affects both literacy
and wealth. Competing explanations for the relationship between literacy and wealth
tend to fall into two broad categories: those focusing on cognitive ability and those
emphasizing the role of incentives in accumulating knowledge.7
The strand of literature on endogenous financial knowledge views financial literacy
as a process subject to marginal incentives similar to the ones governing physical or
human capital accumulation. Lusardi et al. (2013) and Jappelli and Padula (2013),
for example, model financial knowledge investment as an endogenous choice variable,
where more knowledge buys more favorable asset returns. Because the marginal
5
An incomplete list of the large household portfolio choice literature includes Heaton and Lucas (2000),
Viceira (2001), Vissing-Jorgensen (2002), Haliassos and Michaelides (2003), Cocco et al. (2005), Cocco
(2005), Yao and Zhang (2005), Polkovnichenko (2007), and Wachter and Yogo (2010).
6
Lusardi and Mitchell (2014) discuss the empirical evidence pointing to substantial variation in financial
literacy, and they review studies that allow for the endogenous accumulation of financial knowledge.
7
The literature on cognition generally focuses on trend changes in ability with age or the vulnerability of
cognition to life events, such as the loss of a spouse or a medical condition. Agarwal et al. (2009) cite
evidence that cognition declines with age and document a link between age and financial mistakes.
Korniotis and Kumar (2011) find that older investors perform worse in terms of both stock selection
and diversification. Van Rooij et al. (2011) argue that cognition does not merely follow a smooth
trend over the life cycle, but may instead be a function of life circumstances.
benefits of knowledge investment are a function of the level of financial wealth, the
model produces hump-shaped profiles of the stock of financial knowledge that mirror
the path of financial wealth over the life cycle.8 Spataro and Corsini (2013) introduce
human capital into a similar framework, which delivers the added insight that higher
levels of education tend to increase endogenous financial literacy and thereby increase
wealth accumulation and capital market participation.
In addition to influencing wealth, financial literacy can also affect portfolio deci-
sions and stock market participation. Kim et al. (2013) incorporate time costs of in-
vestment management and show that inertial portfolio allocations are consistent with
optimal behavior. Empirically, there is evidence that lower financial sophistication is
associated with inefficient investment strategies and non-participation in the stock
market (Calvet et al., 2007; Kimball and Shumway, 2010; Yoong, 2011). In a similar
vein, Guiso and Viviano (2014) examine the decisions of investors from 2007 to 2009
using detailed administrative data and find that financially literate investors are better
at timing the market and choose allocations that are more in line with the standard
prescriptions of the Capital Asset Pricing Model (CAPM). However, they also find
a surprisingly larger number of financially sophisticated investors who make common
investment mistakes.
Of course, financial literacy may not be the only reason why some investors make
bad financial decisions. Hastings and Mitchell (2011) examine the importance of ‘pre-
sent bias’ as an alternative explanation for poor decision making. In addition to
administering questions on financial literacy (covering basic concepts like compound-
ing, inflation, and returns) in a nationally representative Chilean panel survey, they
also conducted experiments aimed at identifying impatience and the ability to carry
out intended financial decisions.9 Their results indicate that impatience is negatively
associated with the likelihood of saving in a voluntary saving plan, as well as wealth
accumulation. Financial literacy was not significantly related to participation in the
saving plan, but it was positively correlated with wealth accumulation.
3 Model of hyperbolic discounting, and portfolio choice

Our model builds on previous studies of life-cycle portfolio choice (e.g., Cocco et al.,
2005; Gomes and Michaelides, 2005) by introducing a role for hyperbolic discounting
(Laibson, 1997; Harris and Laibson, 2001). Households live for a maximum of T
periods. At the beginning of each period t ≤ T, households form expectations of
survival, income, and asset returns and then choose consumption, Ct, stock-market
participation, χt, and portfolio share in stocks, αt ∈ [0, 1].
As in Gomes and Michaelides (2005), we assume that households have Epstein–Zin
preferences over consumption and bequests (Epstein and Zin, 1989). In addition, how-
ever, we introduce time-inconsistent preferences into the Epstein–Zin recursion. From
8
An implication of the twin trajectories of wealth and knowledge is that endogenous financial knowledge
increases predicted wealth inequality: higher-income individuals who have a strong incentive to build up
wealth also have more to gain by investing in higher returns (Lusardi et al., 2013).
9
They tested impatience by asking respondents whether they would like to fill out a short questionnaire
immediately for a 5,000 peso gift card at a major shopping chain or submit the questionnaire by mail
in exchange for a delayed payment of 6,000–8,000 pesos.
the standpoint of period t, households discount all future periods using a standard
geometric discount factor, δ, except for the time period immediately following t,
which they discount according to an additional factor β. As is standard in the hyper-
bolic discounting literature (see, e.g., Harris and Laibson, 2001), we draw a distinction
between the current value function, which reflects period t’s hyperbolic future dis-
counting, and the continuation value function, which applies geometric discounting.
The current and the continuation value functions each depend on the level of cash
on hand, Xt, permanent income, Pt, and an indicator variable for whether they par-
ticipated in the stock market last period, χt−1. Let Vt ≡ Vt(Xt, Pt, χt−1) denote the re-
cursive continuation value function:
1−(1/σ)/1−γ 1/1−(1/σ)
1−γ
Vt = (1 − δ)Ct1−(1/σ) +δ Et [ pt Vt+1 ] , (1)
where σ is the EIS, γ is the coefficient of risk aversion, pt is the probability of living to
period t + 1 conditional on being alive in period t.10
The current value function, Wt ≡ Wt(Xt, Pt, χt−1), is then given by:
1−(1/σ)/1−γ 1/1−(1/σ)
1−(1/σ) 1−γ
Wt = (1 − δ)Ct + βδ Et [ pt Vt+1 ] . (2)
Households will choose optimal values of consumption, portfolio allocation, and

stock market participation by maximizing their current value functions.11 In some
cases, we will assume that hyperbolic discounters are sophisticated (Laibson, 1997)
and understand that their future selves will also behave hyperbolically. In other
cases, we will assume that households are naive, in that they believe their future selves
will always discount the future geometrically.
Cash on hand evolves as follows:
Xt+1 = Rt+1 (Xt − Ct ) + Yt+1 − FId Pt+1 , (3)
where Yt+1 is income net of taxes, transfers, and medical costs, F is the fixed cost of
entering the stock market, Id is an indicator variable for whether the household is
participating in the stock market for the first time, and Rt+1 is the gross asset rate
of return:

Rt+1 = αt Rs − R + R.
(4)
t+1
10
One could easily include a bequest motive by, for example, letting preferences be given by
1−1/σ/1−γ 1/(1−1/σ)
1−γ 1−γ
Vt = (1 − δ)Ct1−1/σ + δ Et [ pt Vt+1 + (1 − pt )bXt+1 ] , where b is a parameter govern-
ing the importance of bequests. We have solved the model with and without an explicit bequest motive,
but we focus on the case without a bequest motive since the qualitative results regarding saving and par-
ticipation are the same in both cases.
11
Another way to introduce hyperbolic discounting into Epstein–Zin preferences is change the weights on
the consumption and expected value components of the preferences from (1−δ) and δ to (1 − βδ) and βδ.
The advantage of our formulation is that it nests the CRRA case, in the sense that the consumption rules
in a standard hyperbolic discounting model with CRRA utility are identical to the decision rules in the
Epstein-Zin case with σ = 1/γ.
3.1 Optimal consumption and portfolio choice

3.1.1 Consumption First-order Condition (FOC)
1/(1−γ)
1−γ
Letting μt+1 = Et [pt Vt+1 ] , the first-order for consumption required to maxi-
mize Wt is given by:
γ−(1/σ) −γ
(1 − δ)Ct−1/σ = βδμt+1 Et pt Vt+1 Vt+1,X Rt+1 . (5)
The first-order condition requires that the weighted marginal benefit of consuming
today equals the (hyperbolically and geometrically) discounted expected marginal
value of saving next period.12 We can gain more insight into the role of hyperbolic
discounting, by deriving consumption Euler equations for sophisticated and naive
hyperbolic households.
We will first consider the Euler equation for sophisticated households. Adapting the
Euler equation derivation in Harris and Laibson (2001) to the Epstein–Zin case, we
begin by noting that optimality requires that:
Wt−1/σ Wt,X = (1 − δ)Ct−1/σ . (6)
We also know that:
1−1/σ 1−1/σ 1−1/σ

βVt+1 − Wt+1 = (1 − δ)(β − 1)Ct+1 . (7)
Taking the derivative of the above expression with respect to cash on hand, Xt+1,
we have:
−1/σ −1/σ −1/σ

βVt+1 Vt+1,X = Wt+1 Wt+1,X − (1 − δ)(1 − β)Ct+1 Ct+1,X . (8)
Rolling equation (6) forward one period and substituting, we have:
−1/σ −1/σ −1/σ

βVt+1 Vt+1,X = (1 − δ)Ct+1 − (1 − δ)(1 − β)Ct+1 Ct+1,X . (9)
γ−(1/σ) 1/σ−γ
Multiplying both sides by δpt μt+1 Vt+1 Rt+1 , the equation becomes:
βδμγ−1/σ −γ γ−1/σ
t+1 pt Vt+1 Vt+1,X Rt+1 = pt μt+1 [(Ct+1,X βδ +
−1/σ 1/σ−γ
(1 − Ct+1,X )δ)Ct+1 Vt+1 Rt+1 (1 − δ). (10)
12
In the case of hyperbolic discounting, the standard envelope condition relating Vt,x to Ct−1/σ must be modified
to account for the response of consumption to cash on hand, which cancels out by application of the first-
order condition in the standard formulation. In particular, Vt,x = Vt1/σ (1 − δ)Ct−1/σ [Ct,x + (1 − Ct,x )/β],
where the term in brackets is the new term introduced by hyperbolic discounting. The marginal value func-
tion will be higher than the marginal utility of current consumption as long as there is a positive amount of
saving, which receives ‘exponential,’ rather than the lower ‘hyperbolic,’ credit in next period’s value function.
Taking expectations of both sides and substituting the FOC for consumption, we
arrive at the Euler equation for sophisticated hyperbolic discounters:
γ−1/σ
Ct−1/σ = μt+1 −1/σ 1/σ−γ
Et [(Ct+1,X βδ + (1 − Ct+1,X )δ)Ct+1 Vt+1 Rt+1 ]. (11)
As in Harris and Laibson (2001), the effective discount factor on the right-hand side
is a weighted average of βδ and δ, where the weights are the marginal propensity to
consume (Ct+1,X) and the marginal propensity to save (1 − Ct+1,X) next period. In
the special case where 1/σ = γ, the right-hand side of the Euler condition is exactly
the same as the CRRA case considered in Harris and Laibson (2001), and it is
straightforward to show that the two models will deliver the same consumption
rules (see Appendix 6).
In the event that the liquidity constraint binds (i.e., Ct > Xt), we simply set Ct = Xt.
We solve the model using the method of endogenous gridpoints (Carroll, 2006), which
solves for the values of optimal consumption and cash on hand implied by a range of
end-of-period saving. One of the advantages of the method is that we can solve for the
values of consumption and cash on hand at precisely the point at which the constraint
starts to bind (i.e., when end-of-period saving is zero). Letting Xt denote the lowest
level of cash on hand at which the constraint is nonbinding, we set Ct = Xt for all
X t , Xt .
3.1.2 Portfolio share FOC

The first-order condition for portfolio choice is:

Et −γ
pt Vt+1 = 0,
Vt+1,X At (Rst+1 − R) (12)
where At = Xt−Ct denotes end-of-period saving. The first-order condition says that
the expected marginal value (first term in parentheses) of placing another increment
of end-of-period saving in stocks and exchanging more risk for higher return (second
term in parentheses) is zero. It is worth noting that even though the discount factors
do not show up directly in the first-order conditions for portfolio allocation, they in-
directly affect these decisions through the choice of saving, At, and the expected values
of Vt+1, and Vt+1,x. We handle corner solutions in the usual way. If the left-hand side
of equation (12) is less than zero at α = 0, then we set α = 0. If the left-hand side of
equation (12) is greater than zero at α = 1, we set α = 1.
3.2 Parameterization and normalization of the model

3.2.1 Preferences
Table 1 summarizes the baseline specification of the model. We assume that house-
holds geometrically discount the future at a factor of 0.97 per year, and that hyper-
bolic discounters apply an additional discount factor of 0.70 per year, a value that
is consistent with experimental evidence on 1-year discount factors (Angeletos
et al., 2001). In all of our specifications, we set the coefficient of relative risk aversion
Table 1. Baseline parameters for simulations
Parameter Value
Risk aversion (γ) 5

Geometric discount factor (δ) 0.97
Hyperbolic discount factor (β) 0.7 or 1.0

Risk-free gross return (R) 1.02
s
Risk premium (Et (Rt+1 − R)) 0.04
Std. of risky asset 0.18
Price of financial knowledge as fraction of age-20 permanent income (ϕ) 0.005
Fixed cost as fraction of age-20 permanent income (F) 0.10
Maximum loss of equity premium (λ) 0.90
Curvature on knowledge function for return (ν) 0.50
Depreciation rate of financial knowledge (d) 0.10
Retirement income risk? No
This table presents the baseline set of parameters for the model simulations. We do not list a
benchmark value of the EIS (σ) since we vary that parameter from 0.1 to 0.9, depending on
the exercise. Unless otherwise noted, the simulations pertain to high-school graduates, who dif-
fer from college graduates only in their income trends and variance decomposition (see
Table 2).
(γ) to 5, which is high enough to push households away from a corner allocation
solution of 100% stocks. We do not fix a baseline value of the EIS (σ), but instead
present results for EIS values in the range of 0.1–0.9.
3.2.2 Income
Household income follows the standard process in the life-cycle consumption litera-
ture (see, e.g., Carroll, 1997), consisting of a deterministic age profile and transitory
and permanent shocks. Specifically,
Yt+1 = Pt+1 Θt+1 , (13)
Pt+1 = Pt Nt+1 Gt+1 , (14)
where Θt+1 is a log-normally distributed transitory shock, Nt+1 is a log-normally dis-

tributed permanent shock, and Gt+1 is the growth rate of the age profile of earnings. In
retirement, the income process is net of out-of-pocket medical costs (see Love, 2010).
The presence of uncertainty in retirement income can play an important role in the
portfolio and saving decisions of older households. Nevertheless, we shut down this
source of uncertainty in our baseline specification since there is less agreement in
the literature on how to model medical expense risk in models that have been normal-
ized (as ours will be) by permanent income. We adopt the specifications of income for
high school and college graduates from Love (2013). The income profiles for both
education groups trace out the familiar hump shape in the literature. College
Table 2. Variance decomposition of income in working period and retirement
High school College
Working period Retirement Working period Retired
Permanent (σ 2η ) 0.0087 0.0125 0.0120 0.0281

(0.0002) (0.0026) (0.0003) (0.0027)
Transitory (σ 2e ) 0.0896 0.0784 0.0851 0.0767
(0.0013) (0.0070) (0.0018) (0.0075)
This table presents the variance composition used in the model solutions and simulations. The
estimation procedure for the error structure follows Carroll and Samwick (1997). The variance
decomposition for the working years is taken from Love (2013). The variance decomposition
for the retirement period applies to income net of medical expenses, and the estimates are
taken from Love (2010).
graduates have steeper profiles when young and experience a larger average drop in
permanent income in retirement (26% for college graduates vs. 16% for high-school
graduates). Table 2 reports the variance decomposition for the two education groups
during the working years and in retirement.
3.2.3 Asset returns

We choose values for the asset return process that are standard in the life-cycle port-
folio choice literature. We set the risk-free rate to 2%, the equity premium to 4%, the
standard deviation of the risky asset to 0.18, and assume zero correlation between the
risky asset and labor income.13 The fixed cost of entering the stock market for the first
time is F = 0.10.
3.2.4 Normalization
The Epstein–Zin value function is homogenous of degree 1, which makes it possible
to normalize the problem by permanent income, Pt. Letting vt ≡ Vt/Pt, wt ≡ Wt/Pt,
xt = Xt/Pt, ct = Ct/Pt, and μ̂t+1 = Et [pt (Nt+1 Gt+1 vt+1 )1−γ )1−γ ], the normalized optimiza-
tion problem is now:
wt (xt ,χ t−1 ) = max {(1 − δ)ct1−1/σ + βδμ̂1−1/σ
t+1 }
1/(1−1/σ)
, (15)
ct ,αt
subject to:
Rt+1
xt+1 = (xt − ct ) + Θt+1 − F , (16)
Γt+1
αt [ [0,1]. (17)
The final constraint rules out short sales and leverage in the stock market.
13
See Cocco et al. (2005) and Love (2013) for a discussion of similar choices.
Figure 1. (colour online) Consumption decision rules and the EIS: this figure shows
consumption decision rules for high-school graduates with a geometric discount factor δ =
0.97, coefficient of relative risk aversion, γ = 5, and EIS parameters of 0.2 (left panel) and
0.5 (right panel), respectively.
4 Hyperbolic discounting and Epstein–Zin

How does hyperbolic discounting affect decisions regarding consumption, allocation,
and participation when the EIS is allowed to change independently of risk aversion?
We examine the interaction between the EIS and hyperbolic discounting by analyzing
the consumption and allocation decision rules, as well as the simulated wealth and
participation profiles.
4.1 Consumption rules

Figure 1 shows how hyperbolic discounting affects the role of the EIS in shaping con-
sumption decisions. The left panel of the figure shows the standard case of sophisti-
cated hyperbolic discounting when the EIS is the inverse of risk aversion (the
standard CRRA case). Here, we can see the familiar features of the buffer-stock con-
sumption rules (Zeldes, 1989; Carroll, 1992), with kinks at the onset of saving and a
nearly linear slope thereafter. Hyperbolic discounting decreases consumption at all
points after the constraint ceases to bind, but the difference in the two decision
rules is not dramatic.
The right panel of the figure shows what happens when we increase the EIS param-
eter from 0.2 to 0.5, holding the coefficient of relative risk aversion constant at
5. Compared to the left panel, the spread between the geometric and hyperbolic de-
cision rules is noticeably larger at all points after the kink. At lower levels of cash
on hand, the difference appears to be driven more by a decline in the geometric indi-
vidual’s consumption than an increase in that of the hyperbolic individual. At higher
levels of cash on hand, however, most of the difference between the lines is due to the
increased consumption of the hyperbolic discounter. Although we only present the de-
cision rules for two values of the EIS, the same pattern holds for the full range of EIS
parameters we considered. In all cases, higher values of EIS generate larger gaps in the
consumption rules of hyperbolic and geometric discounters.
Why do higher values of the EIS tend to increase the consumption rules of hyper-
bolic individuals, but decrease those of geometric discounters? Optimal consumption
involves a tradeoff between the endogenous rate of return on savings and the discount
rate. When the expected endogenous return to saving is high relative to the discount
rate, higher values of the EIS will tend to increase saving (Campbell and Viceira,
1999; Gomes and Michaelides, 2005), as in the non-hyperbolic case shown in
Figure 1. When the expected return to saving is lower than the discount rate, however,
the effect works in the opposite direction, with higher EIS values leading to less sav-
ing. Thus, higher values of the EIS push ‘savers’ to save even more. Hyperbolic dis-
counters, in contrast, find themselves tempted to consume more in the present. In their
case, the higher willingness to substitute consumption across time periods actually
exacerbates their self-control problem.
We can see this more formally by considering the hyperbolic Euler condition given
in equation (11). To keep things simple, assume that there are no sources of risk, so
that μt = Vt, and set Rt = R. Optimal consumption is then given by:
−σ
Ct = (1 − δ)σ R(Ct+1,X βδ + (1 − Ct+1,X )δ) Ct+1 ,
where the term in brackets is the effective discount rate in the hyperbolic Euler equa-
tion times the gross rate of return. In the geometric case, the bracketed term would be
replaced by Rδ, which will be larger than the effective discount factor as long as Ct+1,
X > 0. Hyperbolic discounting makes it more likely that the term in brackets falls
below 1, in which case higher values of the EIS would tend to increase, rather than
decrease, consumption.
4.2 Allocation rules

In contrast to the case of consumption, hyperbolic discounting has only a slight effect
on the portfolio decisions. Figure 2 displays the allocation rules for hyperbolic and
geometric discounters with an EIS of 0.5. Hyperbolic discounters place slightly
more of their portfolios in the risk asset, but one has to stare to detect the differences.
The differences do grow at larger EIS values, but even when the EIS = 0.9, the gaps
range between 0.5% and 3.5% points.
Hyperbolic discounting leads to (slightly) higher allocations in the risky assets be-
cause hyperbolic discounters anticipate that they will consume more than they would
presently like in the next period. This has the effect of dampening the expected mar-
ginal utility of consumption in that period, which, in turn, makes ‘down’ states of the
world less painful than otherwise. As a result, they are willing to accept slightly riskier
portfolios for the same amount of end-of-period saving.
4.3 Participation
Although hyperbolic discounting leads to only minor changes in allocation decisions,
it can have a substantial effect on the decision to participate in the stock market.
Figure 3 shows the threshold levels of cash on hand at which individuals decide to
pay the one-time fixed participation cost to start investing in the stock market. The
Figure 2. (colour online) Portfolio decision rule and the EIS: this figure shows the portfolio
allocation decision rules for high-school graduates with a geometric discount factor δ =
0.97, coefficient of relative risk aversion, γ = 5, and EIS parameter 0.5.
thresholds across all specifications tend to fall with age, reflecting the transition from a
buffer-stock saving motive to one of retirement accumulation. Hyperbolic discounting
increases the threshold of participation in each of the panels, but the impact is much
larger in the case of a higher EIS parameter.
We can also see the effect of the EIS parameter on the average simulated participa-
tion decisions of hyperbolic and geometric discounters, shown in Figure 4.14 The
figure shows the average fraction of individuals aged 20–30 who have participated
in the stock market to date. While the participation rates of both types of discounters
tend to increase with the EIS, the spread in the participation rates widens as the EIS
increases. For example, while geometric discounters participate at a rate of about 10%
points higher than that of hyperbolic discounters when the EIS is 0.2, that spread rises
to over 20% points when the EIS is 0.5.
14
In considering the full range of EIS (from 0.1 to 0.9), we solve the model assuming that discounters are
naive. All of the decision rules and simulated outcomes are essentially identical for lower values of the
EIS. At high levels of the EIS, however, the model generates non-monotonic consumption rules in the
sophisticated case, which introduces some complications in the solution method (see Harris and
Laibson (2002) for a similar finding in the CRRA case).
Figure 3. (colour online) Stock market participation threshold and the EIS: this figure
shows the threshold level of cash-on-hand at which individuals participate in the stock
market for high-school graduates with a geometric discount factor δ = 0.97, coefficient of
relative risk aversion, γ = 5, and EIS parameters of 0.2 (left panel) and 0.5 (right panel),
respectively.
4.4 Wealth accumulation

It is well known that hyperbolic discounting reduces total wealth accumulation in a
model without an illiquid asset that can serve as a self-control device. But how
does the impact on wealth depend on the EIS? Figure 5 shows the peak average simu-
lated levels of cash on hand for EIS parameters ranging from 0.1 to 0.9. The top line
displays the peak wealth for geometric discounters, while the bottom line shows peak
accumulation for hyperbolic agents. The striking feature in the figure is that the two
lines move in opposite directions and diverge with increasing levels of the EIS.
Geometric discounters become more willing to shift consumption from the present
to the future when the EIS rises, which will generally be the case when the interest rate
times the discount factor (including the survival probability) is sufficiently high that
an increase in the EIS pushes up the right-hand side of the Epstein–Zin Euler equa-
tion. In the hyperbolic case, however, the increase in the willingness to substitute con-
sumption over time induces less wealth accumulation since the higher EIS magnifies
the temptation to move resources to the impatient present.
The lower wealth accumulation of the hyperbolic agents will have implications for
both stock market participation and asset allocation. Because sophisticated hyper-
bolic discounters understand that they will not build up as much wealth as their geo-
metric counterparts, they correctly place less value on stock market participation. But,
conditional on participating, their lower wealth levels relative to lifetime earnings in-
duce them to take on more portfolio risk (since less of their future consumption is
exposed to the risk of adverse market returns). It may seem counterintuitive that
hyperbolic discounters end up with a higher concentration of stocks than geometric
discounters. As we will see, the introduction of endogenous financial knowledge pro-
vides a channel that operates against the increased stock-market allocations of hyper-
bolic agents: namely, since hyperbolic agents will accumulate not only less wealth, but
Figure 4. (colour online) Average participation rates and the EIS: this figure shows the
simulated average stock market participation rates of high-school graduates aged 20–30
with a geometric discount factor δ = 0.97 and a coefficient of relative risk aversion, γ = 5.
These models were solved assuming naive hyperbolic discounting (see footnote 14 for the
motivation).
also less financial knowledge, they will face less attractive rates of return on the risky
asset compared to geometric discounters.
5 Model of financial knowledge, hyperbolic discounting, and portfolio choice

We now suppose that households invest in a durable stock of financial knowledge over
the life cycle. The introduction of endogenous financial knowledge provides another
channel through which hyperbolic discounting can affect financial investment decisions.
Since hyperbolic individuals place a premium on current consumption, they may be
tempted to underinvest in financial knowledge. In addition, sophisticated hyperbolic in-
dividual recognize that they will accumulate lower lifetime wealth, which dampens both
the incentive to invest in knowledge, as well as the incentive to participate in financial
markets. Finally, because financial knowledge is a durable stock that investors cannot
‘draw down’ to increase consumption, sophisticated hyperbolic discounters may have
an incentive to invest in financial knowledge as a commitment device. This increases
Figure 5. (colour online) Average peak wealth and the EIS: this figure shows the simulated
maximum values of average cash on hand for high-school graduates aged 20–30 with a
geometric discount factor δ = 0.97 and a coefficient of relative risk aversion, γ = 5. These
models were solved assuming naive hyperbolic discounting (see footnote 14 for the
motivation).
future returns, which provides a greater incentive to save in future periods, and it also
‘stores wealth’ (in a shadow value sense) in a protected stock.
Modeling the accumulation of financial knowledge is very difficult, as we know
little about that process, including the rate at which knowledge depreciates, the extent
of diminishing returns, or the marginal cost of accumulating knowledge. Thus, this
section is meant to suggest a way forward for the inclusion of financial literacy and
the interaction with portfolio choice and hyperbolic discounting.
5.1 Model
At the beginning of each period t ≤ T, households choose knowledge investment, ιt.
The stock of financial knowledge, kt, depreciates at rate dt, which can potentially
depend on age. Letting ιt denote the amount of irreversible knowledge investment
in period t, the stock of financial knowledge evolves according to the familiar accumu-
lation equation:
kt = kt−1 (1 − dt ) + ιt . (18)
The price of financial knowledge investment is given by a fraction ϕt of permanent

income, which is meant to reflect both direct outlays on financial advice as well as the
opportunity cost of time. The benefits of knowledge investment come from a lower
fixed cost of initial investment and a higher equity premium on stocks. Conditional
on entering the stock market for the first time, households pay a fixed cost of F(kt)
times their permanent income, where Fk(kt) < 0 and Fkk(kt) > 0. The fixed cost func-
tion used in the remainder of the paper is:
1
F(kt ) = F . (19)
1 + ktρ
where ρ ∈ [0, 1).15

Once households participate in the stock market, they expect to receive an equity
premium that depends on their level of financial knowledge. Let z(kt) be the loss in
due to imperfect financial knowledge, with zk(kt) <0
the equity premium, Rst − R,
and zkk(kt) >0. The specific loss function considered in the paper is:
1
z(kt ) = λ , (20)
1 + ktν
so that the loss is no larger than the equity
where ν ∈ [0, 1), and λ ≤ Et (Rst − R),
premium itself.
The current and continuation value functions now depend on financial knowledge
from the previous period, kt−1. Let Vt ≡ Vt(Xt, Pt, kt−1, χt−1). Cash on hand evolves as
follows:

Xt+1 = Rt+1 Xt − Ct − ϕιt Pt + Yt+1 − F (kt )Id Pt+1 , (21)
where the gross asset rate of return now includes loss due to imperfect financial knowl-
edge:

Rt+1 = αt Rst+1 − R − z(kt ) + R.
(22)
5.1.1 Knowledge investment and optimal decisions

Financial knowledge modifies the optimal portfolio share condition to

Et −γ
pt Vt+1 − z(kt )) = 0,
Vt+1,X At (Rst+1 − R (23)
where At = Xt − Ct − ϕPt ιt denotes end-of-period saving. The first-order condition

says that the expected marginal value (first term in parentheses) of placing another
increment of end-of-period saving in stocks and exchanging more risk for higher re-
turn (second term in parentheses) is zero. The presence of the z(kt) function in the
equity premium term indicates that lower financial knowledge should lead to a
more conservative asset allocation.
15
We also experimented with other forms for the knowledge costs, such as F (kt ) = F ρkt , and we find simi-
lar qualitative results.
The first-order condition for financial knowledge is:

−γ −γ
Et [ pt Vt+1 Vt+1,X + (1 − pt )bXt+1 (−ϕt Pt Rt+1 − αt zk (kt )At − Id Fk (kt )Pt+1 )
−γ (24)
+ pt Vt+1 Vt+1,k ] ≥ 0,
with equality in the case of an interior solution. Since this first-order condition is new,
it is worth reviewing the intuition behind each of the main terms in the expression.
The first term in parentheses inside the expectations brackets captures the marginal
value of cash on hand next period. The next expression in parentheses shows how a
new marginal unit of financial knowledge investment affects cash on hand next
period. On the one hand, each unit of investment costs ϕtPtRt+1 in future wealth.
This marginal cost must be traded off against two sources of marginal benefits.
First, financial knowledge improves the rate of return on the household’s stockhold-
ing, αtAt, by −zk(kt). Second, if this is the first time the household participates in the
stock market, the financial knowledge investment also reduces the size of the fixed
cost by − Fk(kt)Pt+1. Finally, financial knowledge directly increases next period’s
−γ
value function by pt Vt+1 Vt+1,k . It pays to invest in financial knowledge right up to
the point at which the expected marginal costs equal the expected marginal benefits.
Additional intuition can be gained by examining the envelope condition for finan-
cial knowledge for cases in which there is an interior solution. Taking the derivative of
the value function with respect to financial knowledge in period t, we have:

Vt,k = δVt1/σ μγ−1/σ −γ
t+1 Et [ pt Vt+1 Vt+1,X (−αt zk (kt )At − Id Fk (kt )Pt+1 )
−γ
+ pt Vt+1 Vt+1,k ](1 − d). (25)
Substituting the interior FOC for financial knowledge into the above, we have:
γ−1/σ −γ
Vt,k = δVt1/σ μt+1 Et [ pt Vt+1 Vt+1,X (ϕt Pt Rt+1 )](1 − d), (26)
= ϕt Pt (1 − d)Vt,x . (27)
Rolling forward and substituting back into the first-order condition for financial
knowledge, we can write the interior first-order condition as:
−γ
Et [ pt Vt+1 Vt+1,X ϕt Pt (rt+1 + d) + αt zk (kt )At + Id Fk (kt )Pt+1 ] = 0, (28)
where rt+1 = Rt+1 − 1 is the portfolio rate of return.16 We can interpret ϕtPt(rt+1 + d) as
the user cost of financial knowledge, so that the first-order condition equates the mar-
ginal costs and benefits of financial knowledge, weighted by the marginal value of
cash-on-hand in period t + 1.
Since knowledge investment is irreversible, however, it will sometimes be optimal
for households to invest nothing in financial knowledge. This can even be the case
at low levels of financial knowledge since the costs are linear in investment while
16
Note that this first-order condition also assumes an interior financial knowledge solution in period t + 1
since we rolled forward the envelope condition Vt,k = ϕt Pt (1 − d)Vt,x , and the envelope condition
assumed an interior solution in period t.
the benefits depend on present and future expected stockholding. Low wealth house-
holds or households with limited stockholding gain comparatively little from financial
knowledge.
It is worth noting that even though the discount factors do not show up directly in the
first-order conditions for knowledge investment, they indirectly affect these decisions
through the choice of saving, At, and the expected values of Vt+1, Vt+1,x, and Vt+1,k.
The normalized optimization problem is now:
wt (xt ,kt−1 ,χ t−1 ) = max {(1 − δ)ct1−1/σ + βδμ̂t+1
1−1/σ 1/(1−1/σ)
} , (29)
ct ,αt ,ιt
subject to:
Rt+1
xt+1 = xt − ct − ϕt ιt + Θt+1 − F (kt ), (30)
Γt+1
kt = kt−1 (1 − dt ) + ιt ,ιt ≥ 0, (31)
αt [ [0,1]. (32)
One minor issue related to the normalization by permanent income is that it implies
that a constant financial knowledge price, ϕt = (, would result in the price of financial
knowledge rising when permanent incomes increased and falling when they decreased.
This may be reasonable if we interpret the investment cost as an opportunity cost of
time, which is more valuable in higher income states of the world, but we are assum-
ing in our model that labor is supplied inelastically. In our setup, the predictable
changes in the price of financial knowledge would generate strategic behavior (e.g.,
waiting until retirement to take advantage of a sudden decline in permanent income
and therefore the price of knowledge) that is not the focus of our paper. Instead, we
neutralize all of the predictable changes in financial knowledge over the life cycle by
assuming:
ϕt−1
ϕt = . (33)
Gt
This formulation guarantees that ϕtPt = Et[ϕt+τPt+τ] for all values of τ ≤ T − t.
5.1.2 Financial knowledge parameters

Relative to the income and asset return processes, there is less guidance when it comes
to the parameterization of financial knowledge. Our primary motivation in specifying
the marginal costs and benefits of financial knowledge was making sure that the
model delivered interior solutions for financial knowledge investment at least some
of the time. (If the price of knowledge is too low or the efficiency too high, households
accumulate enough knowledge early on that it has essentially no impact on saving or
portfolio decisions. In contrast, if the price is too high or the benefits too low, then it
will be optimal to accumulate no knowledge.)
Data on individual portfolio mistakes suggest that losses occur from a combination
of poor diversification, active trading, and high-fee mutual funds. Lower diversifica-
tion does not affect mean returns but it lowers the denominator of Sharpe ratios.
Calvet et al. (2007) provide a detailed analysis of the efficiency of household portfolios
in Sweden and find that the median household experiences a Sharpe ratio about 65%
of that for a benchmark complete portfolio. In addition, they find corresponding re-
turn losses (relative to a currency-hedged world index) of 1.17%. While these losses
are not dramatic, some households in their study hold highly inefficient portfolios,
with 5% of households experiencing return losses of over 5% relative to the bench-
mark (and assuming a 6.7% equity premium).17 These losses are consistent with recent
work using Dutch data by Gaudecker (2015), who finds an average return loss of 1.8%
at the top quintile of the loss distribution, with the largest losses experienced by house-
holds with low financial literacy.
For the baseline specifications, we assume that households with zero financial knowl-
edge lose 90% of the equity premium (i.e., λ = 0.9). While it may seem extreme that a
household with no financial knowledge forfeits most of the equity premium, the knowl-
edge function generates a very high return to the first unit of financial knowledge. In
particular, a household with just one unit of knowledge will receive 55% of the pre-
mium. We assume that a unit of financial knowledge costs 0.005 of age-20 permanent
income. We set the curvature parameter governing the efficiency of knowledge invest-
ment in reducing the loss in the
√ equity premium (ν) to 0.5, so that the main part of the
functions reduces to: 1/(1 + k). Finally, we assume that financial knowledge depreci-
ates at a rate of 10% per year. Given the arbitrary nature of these assumptions, we also
consider a range of alternative choices of the price of knowledge, the curvature of the
knowledge function, and the depreciation rate of financial knowledge.
5.2 Decision rules

Figure 6 shows the decision rules for financial knowledge investment for hyperbolic
and geometric discounters with an EIS of 0.5.18 For sufficiently low levels of
cash-on-hand, it does not pay to invest in financial knowledge since the expected levels
of saving in future periods are low (or zero), and the borrowing constraint is currently
binding. Once the individual starts to save, however, knowledge investment increases
rapidly with cash on hand until the decision rule begins to taper off as resources in-
crease beyond about 3 times permanent income. The tapering off reflects a combin-
ation of three factors: the diminishing returns to financial knowledge investment,
the reduction in the marginal value of wealth in future periods (which reduces the
pain of receiving lower returns in bad states), and the change in the optimal portfolio
from stocks to bonds (see above), which naturally lowers the marginal benefit of
achieving a higher equity premium through better financial knowledge. The last of
these effects explains why there is a kink in the decision rule at roughly the same
level of cash on hand as individuals are no longer at a corner solution of 100% stocks
in their portfolios.
17
It is worth keeping in mind that these return losses are on the complete portfolio. The losses on just the
risky portion of the portfolio are about three times as large at the median.
18
The figures for financial knowledge display units of financial knowledge, which can be reinterpreted in
financial terms by keeping in mind that each unit costs 0.005 of a 20-year-old’s permanent income. This
implies that a unit of financial knowledge costs around $100 for a typical high-school graduate.
Figure 6. (colour online) Knowledge investment decision rule: this figure shows the
knowledge investment decision rules for high-school graduates with a geometric discount
factor δ = 0.97 and a coefficient of relative risk aversion, γ = 5. The initial level of financial
knowledge is set to zero. The y-axis shows units of financial knowledge, which can be
converted into financial terms by recalling that each unit of financial knowledge costs 0.005
of a 20-year-old’s permanent income.
The figure also suggests that hyperbolic discounting does not have a marked influ-
ence on financial knowledge decisions, conditional on the level of cash on hand. It
does have an effect, however, which is more easily seen when we focus on a smaller
range of cash on hand. Figure 7 plots the decision rules for financial knowledge for
EIS parameters of 0.2 (left panel) and 0.5 (right panel). At the lower EIS, the differ-
ences in knowledge investment are small but perceptible. The differences rise with the
higher EIS parameter (and continue to rise at higher EIS values), but they do not sug-
gest an overwhelming effect of hyperbolic discounting on the investment rate in finan-
cial knowledge.
5.3 Knowledge accumulation

Hyperbolic discounting does, however, lead to substantially different levels of accu-
mulated financial knowledge. Figure 8 displays the average simulated levels of finan-
cial knowledge for individuals with EIS parameters of 0.2 (left panel) and 0.5 (right
panel). The hump shape of the profiles mirrors the accumulation and decumulation
Figure 7. (colour online) Knowledge investment and the EIS: this figure shows the
knowledge investment decision rules for high-school graduates with a geometric discount
factor δ = 0.97, coefficient of relative risk aversion, γ = 5, and EIS parameters of 0.2 (left
panel) and 0.5 (right panel), respectively. The initial level of financial knowledge is set to
zero. The y-axis shows units of financial knowledge, which can be converted into financial
terms by recalling that each unit of financial knowledge costs 0.005 of a 20-year-old’s
permanent income.
Figure 8. (colour online) Simulated financial knowledge and the EIS: this figure shows the
average levels of financial knowledge for high-school graduates with a geometric discount
factor δ = 0.97, coefficient of relative risk aversion, γ = 5, and EIS parameters of 0.2 (left
panel) and 0.5 (right panel), respectively. The y-axis shows units of financial knowledge,
which can be converted into financial terms by recalling that each unit of financial
knowledge costs 0.005 of a 20-year-old’s permanent income.
patterns of financial wealth, with the exception of the ‘knob’ of financial knowledge
accumulation in the early years of the life cycle. The knob coincides with the rapid
increase in stock market participation, and therefore the incentive to lower participa-
tion costs by investing in knowledge.
While hyperbolic discounting visibly suppresses the level of financial knowledge in
each panel, the effect is much larger in the case of a higher EIS. We know from the
model without financial knowledge that higher EIS values drive an increasing wedge
Figure 9. (colour online) Simulated financial knowledge and depreciation: this figure shows
the average levels of financial knowledge for high-school graduates with a geometric
discount factor δ = 0.97, coefficient of relative risk aversion, γ = 5, EIS of 0.5, and
knowledge depreciation of 0% (left panel) and 100% (right panel), respectively. The y-axis
shows units of financial knowledge, which can be converted into financial terms by
recalling that each unit of financial knowledge costs 0.005 of a 20-year-old’s permanent
income.
in the wealth accumulation of geometric and hyperbolic individuals. Anticipated

wealth differences cause hyperbolic individuals to invest less in knowledge for a
given level of cash on hand (the vertical difference in the decision rules above), but
the main force explaining the different average levels of knowledge is the realized
lower wealth accumulation of hyperbolic individuals, which directly reduces the
incentives to invest in knowledge.
The evolution of financial knowledge naturally depends on the assumed rate of de-
preciation. Figure 9 shows two extreme cases corresponding to depreciation rates of
0% (left panel) and 100% (right panel). In the case of zero depreciation, the buildup
in knowledge occurs more gradually and reaches a peak later in life compared to the
model with 100% depreciation. Both of these properties emerge from the irreversibil-
ity of financial knowledge in the 0% depreciation case. If knowledge is irreversible,
then individuals will exercise their option to wait, which explains the more gradual
accumulation. But since investment is a one-way street, uncertainty eventually biases
up the total accumulation path in later years (good shocks induce investment, while
bad shocks cannot be absorbed through depreciation). The higher levels in the zero
depreciation cost mostly reflect the cheaper lifetime costs of attaining a given level
of knowledge.
5.4 Stock market participation and allocation

The combination of lower financial knowledge and wealth over the life cycle leads to
widening differences in stock market participation between hyperbolic and geometric
discounters. Figure 10 displays the average participation rates for individuals aged
20–30 for different assumptions about the EIS. As in the model without financial
knowledge, higher EIS values increase the participation rates of geometric individuals
Figure 10. (colour online) Average participation rates and the EIS: This figure shows the
simulated average stock market participation rates of high-school graduates aged 20–30
with a geometric discount factor δ = 0.97 and a coefficient of relative risk aversion, γ = 5.
These models were solved assuming naive hyperbolic discounting (see footnote 14 for the
motivation).
since they anticipate building up larger amounts of wealth. Hyperbolic individuals, in

contrast, actually reduce their participation in response to higher EIS values, and the
differences are large – on the order of 20% points.
Hyperbolic discounting also affects the concentration of portfolios in the risky
asset. Figure 11 presents the average simulated shares in the risky asset for EIS values
of 0.2 (left panel) and 0.5 (right panel). Hyperbolic discounters concentrate more of
their portfolios in risky assets, and the spread in the allocations between geometric
and hyperbolic discounters increases in the retirement years. The reason for the in-
creasing riskiness of the hyperbolic portfolios in retirement follows from their more
rapid rate of wealth decumulation. Because their wealth falls more quickly during re-
tirement, hyperbolic discounters find themselves increasingly less reliant on financial
resources to finance spending, and they are therefore less exposed to the consequences
of market downturns. The higher EIS value exacerbates this effect since the combin-
ation of steeper discounting and declining survival probabilities makes it more attract-
ive for hyperbolic agents to move more resources to the present, which they are more
willing to do the higher the EIS.
Figure 11. (colour online) Simulated portfolio shares and the EIS: this figure shows the
average shares in the risky asset for high-school graduates with a geometric discount factor
δ = 0.97, coefficient of relative risk aversion, γ = 5, and EIS parameters of 0.2 (left panel)
and 0.5 (right panel), respectively.
Table 3. Participation, allocation, financial knowledge, and wealth, by education
High school College
β Age 20–40 Age 41–64 Age 65–80 Age 20–40 Age 41–64 Age 65–80
Participation 0.7 77.5 100.0 100.0 67.4 100.0 100.0

1 87.3 100.0 100.0 83.2 100.0 100.0
Stock share 0.7 99.2 67.6 60.0 99.6 63.2 46.1
1 95.7 52.4 40.5 97.3 51.7 36.0
Fin. Knowledge 0.7 1.5 3.8 3.1 1.6 5.9 5.4
1 2.2 4.8 4.3 2.5 7.2 7.0
Wealth 0.7 66.1 249.4 220.5 76.2 429.1 459.2
(thousands) 1 98.0 379.6 400.8 109.6 601.1 723.6
This table reports the simulated average levels of participation (in percent), allocation in the
risky asset (in percent), financial knowledge, and cash on hand (in thousands of year-2010 dol-
lars) for different age ranges and education levels. β is the hyperbolic discount factor. The simu-
lations were generated from models with a coefficient of relative risk aversion of 5 and an EIS of
0.5. See text for a discussion of the full parameterization.
5.5 Participation, allocation, financial knowledge, and wealth, by education

While education does not directly affect the price or efficiency of financial knowledge,
it can still influence key outcomes in the model through its impact on the income pro-
cess. In particular, since college graduates tend to have steeper income profiles than
high-school graduates, with steeper declines in income at retirement, they are more
likely to face borrowing constraints when young and accumulate wealth more rapidly
in the middle of life. Table 3 reports summary measures of participation, asset alloca-
tion, financial knowledge, and wealth for different age and education groups. College
graduates tend to participate in the stock market at a lower rate when young, reflect-
ing their higher marginal utilities of current consumption in periods when the liquidity
constraint binds.19 In the presence of hyperbolic discounting, the differences in par-
ticipation rates are even larger. Self control makes participating in the stock market
even less attractive to households whose current incomes are low relative to future
incomes. In terms of the risky asset share, college graduates tend to be slightly
more conservative than high-school graduates, reflecting both their (modestly) higher
variance of permanent income (see Table 2) and their more rapid accumulation of
financial assets. They also, however, build up considerably more financial knowledge
than high-school graduates. It should also be noted that since the model does not ac-
count for likely complementarities between education and financial knowledge, the
simulations probably understate the true differences in financial knowledge across
the education groups.
5.6 The role of financial knowledge parameters

The specification of the financial knowledge functions and cost parameters is neces-
sarily somewhat arbitrary. The key features of the specification are that households
face constant marginal costs and diminishing marginal benefits. The quantitative
results of the model, however, naturally depend on the exact cost of a unit of financial
knowledge and the rate at which knowledge investment runs into diminishing returns.
Table 4 reports several summary measures of our outcomes of interest (participation,
allocation, knowledge, and wealth) for difference combinations of the price of knowl-
edge (ϕ = 0.003 and ϕ = 0.007), and the curvature parameter on the impact of knowl-
edge on the equity premium (ν = 0.25 and ν = 0.75). (For reference, recall that the
baseline specification sets ν = 0.50 and ϕ = 0.005.) Higher values of ν generate slower
rates of diminishing returns to the impact of financial knowledge on the equity pre-
mium. The results in the table indicate that higher values of the curvature parameter
lead to modest increases in the participation rate at ages 20–30 when the price of
knowledge is low, and no clear effect when the price of knowledge is high. The
price of knowledge has a noticeably larger impact on participation. Increasing ϕ
from 0.003 to 0.007 reduces participation in the range of 10–15% points, depending
on education and the curvature parameter.
In terms of allocation, the results appear to be relatively sensitive to the choice of
the curvature parameter. Moving from a curvature parameter of 0.25–0.75, for ex-
ample, increases the average risky asset share at ages 40–60 in the neighborhood of
15–20% points. Increasing the price of financial knowledge from 0.003 to 0.007, in
contrast, has a more modest impact on the allocation decisions, in the range of
3–4% points.
Peak financial knowledge and wealth are sensitive to both the curvature parameter,
as well as the price of financial knowledge. Increasing the curvature parameter
19
Because the fixed costs of stock market participation are modeled as a share of permanent income, col-
lege graduates face higher absolute costs of participation than high school graduates. If the fixed costs of
participation were instead modeled as a fixed dollar amount, the participation rates of college graduates
would rise relative to those of high school graduates.
Table 4. Impact of financial knowledge price and financial knowledge parameters
High school College
ϕ = 0.003 ϕ = 0.007 ϕ = 0.003 ϕ = 0.007
β ν = 0.25 ν = 0.75 ν = 0.25 ν = 0.75 ν = 0.25 ν = 0.75 ν = 0.25 ν = 0.75
Participation 0.7 73.8 74.7 65.8 62.6 58.9 64.9 49.6 50.0
1.0 84.8 88.4 84.2 82.3 79.8 83.7 78.9 75.4
Allocation 0.7 64.6 78.4 60.7 74.7 61.7 75.2 57.9 72.4
1.0 47.5 61.7 44.0 58.0 47.9 62.0 44.5 59.0
Max Fin. 0.7 3.8 9.0 1.6 4.7 6.3 12.8 2.6 6.8
Knowledge 1.0 4.8 10.7 2.0 5.7 8.0 15.0 3.3 8.2
Max Wealth 0.7 350.5 390.0 343.0 373.3 675.4 728.3 662.6 708.6
1.0 559.5 630.9 548.5 602.4 971.3 1,079.7 948.3 1,038.0
This table reports the simulated average levels of participation (in percent) at ages 20–30, allo-
cation in the risky asset (in percent) at ages 40–60, financial knowledge, and cash on hand (in
thousands of year-2010 dollars) for different financial knowledge parameters and education
levels. β is the hyperbolic discount factor. φ is the price of a unit of financial knowledge as a
fraction of age-20 permanent income. ν is the curvature parameter on financial knowledge in
the loss function (equation 3). ‘Max knowledge’ is the maximum average simulated level of
financial knowledge. ‘Max wealth’ is the maximum average simulated level of cash on hand.
The simulations were generated from models with a coefficient of relative risk aversion of 5,
a curvature value of ρ = 0.5 on financial knowledge in the fixed-cost function (equation 2),
and an EIS of 0.5. See text for a discussion of the full parameterization.
effectively doubles the maximum accumulation of financial knowledge, and it

increases maximum wealth by over 10% in most cases. Reducing the price of financial
knowledge has a similar impact on the accumulation of financial knowledge, but a
somewhat smaller effect on wealth accumulation.
While it seems unlikely that the literature will ever arrive at a consensus on the exact
parameterization of the financial knowledge function, the results in the table under-
score the potential importance of heterogeneity in the marginal costs and benefits
of financial knowledge. Suppose, for example, that there are strong complementarities
between the level of education and the marginal cost of investing in financial
knowledge.20 In this case, the model can deliver noticeable differences in the partici-
pation and allocation decisions of high school and college graduates even if their in-
come processes are identical. Finally, the sensitivity of the results to the knowledge
parameters also suggests that age differences in the efficiency of financial knowledge
(changing values of ϕ, d, and/or ν) might reinforce the hump-shaped pattern knowl-
edge profiles in the model.
20
Lusardi et al. (2010), for example, find a strong and positive relationship between educational attainment
and financial literacy.
6 Conclusion
This paper studies portfolio allocation in a life-cycle model with recursive Epstein–Zin
preferences, hyperbolic discounting, and financial knowledge investment. We show
that hyperbolic discounting can significantly delay participation in the stock market.
We also show that, because hyperbolic discounting significantly reduces lifetime
wealth accumulation, investors allocate a larger fraction of wealth to risky assets, par-
ticular very late in life. As well, hyperbolic discounting decreases financial knowledge
investment, primarily through the wealth accumulation channel.
All of these results are magnified by a higher EIS. Whereas in a standard life-cycle
model with Epstein–Zin preferences stock market participation rises with higher EIS,
with hyperbolic discounting high levels of EIS lead to lower levels of stock market
participation. Crucially, stock market participation among retirees is significantly
higher for hyperbolic discounters when the EIS is higher. Wealth levels have critical
importance for many life-cycle decisions, and so delayed wealth accumulation arising
from hyperbolic discounting with high EIS can lead to a variety of important behav-
ioral outcomes.
Our model, which combines hyperbolic discounting and recursive preferences, pro-
vides a useful framework for considering how other portfolio decisions are affected by
hyperbolic discounting. Previous studies have investigated how hyperbolic discount-
ing affects the demand for liquid and illiquid assets, and how life-cycle considerations
affect the demand for housing and other types of risky investments. Our model allows
for the joint consideration of illiquidity and risk.
Finally, our paper suggests that the policy implications of hyperbolic discounting
may be more significant than previously thought. Our results show that low levels
of wealth accumulation lead to delayed stock market participation, lower levels of
financial knowledge, and higher concentrations of portfolios in risky assets very
late in life. Automatic or default contributions to retirement and savings account
thus have the beneficial effect of increasing stock market participation when young
and increasing the share of safe investments late in life, precisely when retirees or
soon-to-be retirees are most susceptible to adverse changes in the stock market.
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Appendix 1 Epstein–Zin with Hyperbolic Discounting Nests the CRRA Case

Consider a simplified version of the model without a bequest motive or survival un-
certainty. (It is straightforward to extend the argument for the case of bequests and
survival risk.)
If 1/σ = γ (i.e., EIS = 1/CRRA), the continuation value function becomes:
1/1−1/σ
Vt = (1 − δ)Ct1−1/σ + δEt Vt+1
1−1/σ
. (A.1)
The FOC for consumption in the HD case is then:

(1 − δ)Ct−1/σ = βδEt [Rt+1 Vt+1
−1/σ
Vt+1,x ], (A.2)
where Vt+1,x denotes the derivative of the continuation value function with respect to
−1/σ
cash on hand. As long as Et [Vt+1 Vt+1,x ] = (1 − δ)Et [Vt+1,x
CRRA
], the CRRA and
Epstein–Zin specifications will yield the same consumption rules if 1/σ = γ.
−1/σ
Assume Et [Vt+1 Vt+1,x ] = (1 − δ)Et [Vt+1,x
CRRA
]. The envelope condition implies that:
−1/σ
Vt,x = Vt1/σ δEt [Vt+1 Vt+1,x Rt+1 ]. (A.3)
Thus,
Vt−1/σ Vt,x = δEt [Vt+1
−1/σ
Vt+1,x Rt+1 ]. (A.4)
−1/σ
Substituting Et [Vt+1 Vt+1,x ] = (1 − δ)Et [Vt+1,x
CRRA
], we have:
Vt−1/σ Vt,x = (1 − δ)δEt [Vt+1,x
CRRA
Rt+1 ]. (A.5)
Substituting the envelope condition for the CRRA case, this implies:
Vt−1/σ Vt,x = (1 − δ)Vt,x
CRRA
. (A.6)
Thus, if our assumption holds in period t + 1, it will also hold in period t, and the
CRRA and Epstein–Zin specifications will yield the same decision rules for consump-
tion when σ = 1/γ.
In t = T, CT = XT, and we have:
VT = (1 − δ)1/1−1/σ XT . (A.7)
Thus,
VT−1/σ VT,x = (1 − δ)XT−1/σ = (1 − δ)VT,x
CRRA
, (A.8)
so that we confirm that the Epstein–Zin specification with hyperbolic discounting
nests the standard iso-elastic case.
Appendix 2 Solution Method

Once we have normalized the model by permanent income (see Section 3.2.4), we pro-
ceed to solve the model using the method of endogenous grid points (Carroll, 2006),
as well as many helpful insights contained in Chris Carroll’s lecture notes on solving
dynamic models (Carroll, 2008). We begin with exogenous grids of end-of-period
saving {ai }50

i=1 and financial knowledge {kj }j=1 . The saving grid is triple-exponentially
30
spaced, while the financial knowledge grid is exponentially spaced (the results are not
sensitive to the choice of grid spacing). Assuming that we have solved the model for
period t + 1, we solve period t’s problem as follows.
For each {ai,kj} pair, we first use solve for the optimal choices of allocation (αt) and
knowledge investment (ιt) by solving for the zero root in the first-order conditions
given by equations (12) and (24).21 With these decisions in hand, we then solve for
the optimal value of consumption using equation (11). Finally, we solve for the
current and continuation value functions, as well as the derivatives of these function
with respect to cash on hand and financial knowledge, which we need to solve the next
period’s problem. The final step in the solution is to solve for the level of cash on hand
at which households will choose to participate in the stock market for the first time.
Once we have the decision rules for each time period, we simulate the model using
30,000 different paths of realized incomes and asset returns. The model was solved
using Matlab, and all of the programs are available by request (dlove@williams.edu).
21
We first solve for the optimal choices of investment for 5 discrete choices of the portfolio share and then
use the interpolated optimal investment choices in the optimization of portfolio choice.

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https://doi.org/10.

1017/S1474747215000220 Published online by Cambridge University Press

Hyperbolic discounting and life-cycle portfolio

DAVID LOVE AND GREGORY PHELAN

JEL CODES: G11, G22, D91, E21

Keywords: Hyperbolic discounting, Epstein–Zin, portfolio choice, ﬁnancial literacy.

We explore how a speciﬁc behavioral anomaly – hyperbolic discounting – affects

3 Model of hyperbolic discounting, and portfolio choice

Households will choose optimal values of consumption, portfolio allocation, and

3.1 Optimal consumption and portfolio choice

Wt−1/σ Wt,X = (1 − δ)Ct−1/σ . (6)

We also know that:

1−1/σ 1−1/σ 1−1/σ

−1/σ −1/σ −1/σ

Rolling equation (6) forward one period and substituting, we have:

−1/σ −1/σ −1/σ

3.1.2 Portfolio share FOC

3.2 Parameterization and normalization of the model

Table 1. Baseline parameters for simulations

Risk aversion (γ) 5

Yt+1 = Pt+1 Θt+1 , (13)

Pt+1 = Pt Nt+1 Gt+1 , (14)

where Θt+1 is a log-normally distributed transitory shock, Nt+1 is a log-normally dis-

Table 2. Variance decomposition of income in working period and retirement

High school College

Working period Retirement Working period Retired

Permanent (σ 2η ) 0.0087 0.0125 0.0120 0.0281

3.2.3 Asset returns

4 Hyperbolic discounting and Epstein–Zin

4.1 Consumption rules

4.2 Allocation rules

4.4 Wealth accumulation

5 Model of ﬁnancial knowledge, hyperbolic discounting, and portfolio choice

The price of ﬁnancial knowledge investment is given by a fraction ϕt of permanent

where ρ ∈ [0, 1).15

5.1.1 Knowledge investment and optimal decisions

where At = Xt − Ct − ϕPt ιt denotes end-of-period saving. The ﬁrst-order condition

The ﬁrst-order condition for ﬁnancial knowledge is:

This formulation guarantees that ϕtPt = Et[ϕt+τPt+τ] for all values of τ ≤ T − t.

5.1.2 Financial knowledge parameters

5.2 Decision rules

5.3 Knowledge accumulation

in the wealth accumulation of geometric and hyperbolic individuals. Anticipated

5.4 Stock market participation and allocation

since they anticipate building up larger amounts of wealth. Hyperbolic individuals, in

Table 3. Participation, allocation, ﬁnancial knowledge, and wealth, by education

High school College

Participation 0.7 77.5 100.0 100.0 67.4 100.0 100.0

5.5 Participation, allocation, ﬁnancial knowledge, and wealth, by education

5.6 The role of ﬁnancial knowledge parameters

Table 4. Impact of ﬁnancial knowledge price and ﬁnancial knowledge parameters

High school College

ϕ = 0.003 ϕ = 0.007 ϕ = 0.003 ϕ = 0.007

β ν = 0.25 ν = 0.75 ν = 0.25 ν = 0.75 ν = 0.25 ν = 0.75 ν = 0.25 ν = 0.75

effectively doubles the maximum accumulation of ﬁnancial knowledge, and it

Laibson, D. (1998) Life-cycle consumption and hyperbolic discount functions. European

Appendix 1 Epstein–Zin with Hyperbolic Discounting Nests the CRRA Case

The FOC for consumption in the HD case is then:

Appendix 2 Solution Method

saving {ai }50