Effects of Over and Under-Confidence on Asset Holdings and Net Worth

Abstract

Research in psychology shows that people miscalibrate their ability and often incorrectly perceive themselves as above (overconfident) or below average. Previous measures that proxy for overconfidence focus on perceptions about knowledge pertaining to economic conditions and financial markets since the researchers usually study economic and financial decisions. Our objective is to contribute to this literature by considering a more general proxy of overconfidence. We do so by operationalizing measures of subjective and objective cognitive ability in the Health and Retirement Study to estimate a proxy for overconfidence. This proxy is the residual variation of subjective cognition unexplained by an objective cognitive score and covariates. We find that higher overconfidence leads to a lower chance of an individual having financial assets in nearly all accounts, such as cash-equivalent, stocks, CDs, and savings in various retirement accounts including defined benefits, defined contribution, and individual retirement accounts. Moreover, conditional on ownership, higher confidence leads to a decrease in financial holdings in cash-equivalent assets and thus in total financial assets. Conditional on ownership, more overconfidence leads to an increase in the share of wealth held in less actively managed accounts, such as cash-equivalent, CDs, DB, and other financial assets.