Overconfidence and Consumption over the Life Cycle'

Abstract

Overconfidence is a widely documented phenomenon. In this paper, we study the implications of consumer overconfidence in a life-cycle consumption/saving model. Our main analytical result is a necessary and sufficient condition under which any degree of overconfidence concerning the mean return on savings can produce a hump in the work-life consumption profile. This condition is almost always met in the data. We show by simulations that overconfidence concerning the variance of the return can have little effect on the long-run average behavior of consumption over the life cycle, and that our basic conclusion is fairly robust with various realistic modifications to the baseline model. We interpret the general applicability of our analytical framework and discuss our numerical results in the light of aggregate consumption data.