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Misunderestimation: exponential-growth bias and time-varying returns

Author

Listed:
  • Matthew R Levy

    (London School of Economics)

  • Joshua Tasoff

    (Claremont Graduate University)

Abstract

Exponential-growth bias is the tendency to neglect the compounding of interest. The economics literature has used the fact that a biased agent in many circumstances will underestimate the value of assets that grow according to compound interest. We show that the opposite can also be true. It is always possible to make an agent who underestimates exponential growth to overestimate the value of an asset that grows exponentially. This paradoxical phenomenon arises when interest rates vary over time. This gives rise to the averaging effect of exponential-growth bias, which causes agents to perceive the mean return to exceed the true mean. Consequently, biased agents will strictly prefer assets with time-varying returns over equivalent constant-return assets. With sufficient variation in returns any biased agent will overestimate the true value of an asset for any time horizon.

Suggested Citation

  • Matthew R Levy & Joshua Tasoff, 2016. "Misunderestimation: exponential-growth bias and time-varying returns," Economics Bulletin, AccessEcon, vol. 36(1), pages 29-34.
    • Handle: RePEc:ebl:ecbull:eb-15-00715
    as

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    References listed on IDEAS

    as
    1. Gopi Shah Goda & Colleen Flaherty Manchester & Aaron Sojourner, 2012. "What Will My Account Really Be Worth? An Experiment on Exponential Growth Bias and Retirement Saving," NBER Working Papers 17927, National Bureau of Economic Research, Inc.
    2. Ludwig Ensthaler & Olga Nottmeyer & Georg Weizsäcker & Christian Zankiewicz, 2018. "Hidden Skewness: On the Difficulty of Multiplicative Compounding Under Random Shocks," Management Science, INFORMS, vol. 64(4), pages 1693-1706, April.
    3. Goda, Gopi Shah & Manchester, Colleen Flaherty & Sojourner, Aaron J., 2014. "What will my account really be worth? Experimental evidence on how retirement income projections affect saving," Journal of Public Economics, Elsevier, vol. 119(C), pages 80-92.
    4. Victor Stango & Jonathan Zinman, 2011. "Fuzzy Math, Disclosure Regulation, and Market Outcomes: Evidence from Truth-in-Lending Reform," The Review of Financial Studies, Society for Financial Studies, vol. 24(2), pages 506-534.
    5. Victor Stango & Jonathan Zinman, 2009. "Exponential Growth Bias and Household Finance," Journal of Finance, American Finance Association, vol. 64(6), pages 2807-2849, December.
    Full references (including those not matched with items on IDEAS)

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    More about this item

    Keywords

    exponential-growth bias; compound interest; averaging effect; extrapolation effect;
    All these keywords.

    JEL classification:

    • D0 - Microeconomics - - General
    • D9 - Microeconomics - - Micro-Based Behavioral Economics

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