Working Paper: NBER ID: w26036
Authors: Leandro Carvalho; Dan Silverman
Abstract: Many financial situations present individuals with simple alternatives to solving complex problems. The value of these alternatives depends on whether individuals are sophisticated and know when they are better off opting out of complexity. We tested complexity’s effects and evaluated sophistication in a large and diverse sample. We randomly assigned both complexity to portfolio problems and the offer of a simple alternative to portfolio choice. The less-skilled earn lower returns under complexity because they often opt out when the simple alternative is dominated. To interpret the findings, we develop a novel method for estimating the structural parameters of a rational inattention model. The structural estimates are consistent with substantial sophistication. Large fractions of the money that the low-skilled lose by opting out can be justified by their higher costs of attention.
Keywords: complexity; sophistication; financial decision-making; portfolio choice; rational inattention
JEL Codes: D14; D81; G02; G11
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Complexity (C69) | Lower expected returns (G19) |
| Complexity (C69) | Poorer decision-making quality (D91) |
| Complexity (C69) | Lower risk (G52) |
| Complexity (C69) | Violations of normative choice axioms (D71) |
| Opting out of complexity (L15) | Exacerbation of negative effects (D62) |
| Lower financial decision-making skills (G53) | Rational opting out (D01) |