Present-Bias and the Value of Sophistication

31 Pages Posted: 27 Feb 2021

See all articles by Subas Acharya

Subas Acharya

University of Texas at Dallas - School of Natural Sciences and Mathematics

David Jimenez Gomez

Universidad de Alicante - Department of Economics

Dmitrii Rachinskii

University of Texas at Dallas

Alejandro Rivera

University of Texas at Dallas - School of Management - Department of Finance & Managerial Economics

Date Written: October 31, 2020

Abstract

This paper develops a dynamic wealth management model for risk-averse investors displaying present-bias in the form of hyperbolic discounting. The investor chooses an optimal consumption policy and allocates her funds between a risk-free asset, a traded liquid asset, and a non-traded illiquid asset. We characterize these policies for both sophisticated and naive present-biased investors. There are three results. First, sophisticated investors over-consume more than their naive counterparts if and only if their coefficient of relative risk-aversion is smaller than one. As a result, sophistication is welfare reducing (increasing) when risk-aversion is low (high). Second, increasing asset illiquidity always benefits the sophisticated investor more than the naive investor. Thus, the welfare gap between sophisticated and naive investors is increasing in the proxy for asset illiquidity. Finally, present-biased investors accumulate a larger share of their wealth in the non-traded illiquid asset than in the traded risky stock compared to the neoclassical exponential discounter investor. As a consequence, from the perspective of present-biased investors, the equity premium puzzle (1985) and the private equity puzzle (2002) are two sides of the same coin.

Keywords: Present-Bias, Behavioral Finance, Private Equity Puzzle, Commitment Devices.

JEL Classification: G02, G11, D21

Suggested Citation

Acharya, Subas and Jimenez Gomez, David and Rachinskii, Dmitrii and Rivera, Alejandro, Present-Bias and the Value of Sophistication (October 31, 2020). Available at SSRN: https://ssrn.com/abstract=3722608 or http://dx.doi.org/10.2139/ssrn.3722608

Subas Acharya

University of Texas at Dallas - School of Natural Sciences and Mathematics ( email )

2601 North Floyd Road
Richardson, TX 75083
United States

David Jimenez Gomez

Universidad de Alicante - Department of Economics ( email )

Apartado de Correos 99
Alicante, 03080
Spain

Dmitrii Rachinskii

University of Texas at Dallas ( email )

2601 North Floyd Road
Richardson, TX 75083
United States

Alejandro Rivera (Contact Author)

University of Texas at Dallas - School of Management - Department of Finance & Managerial Economics ( email )

2601 North Floyd Road
P.O. Box 830688
Richardson, TX 75083
United States

HOME PAGE: http://jindal.utdallas.edu/faculty/alejandro-rivera

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