Rules of Thumb in Life‐Cycle Saving Decisions

Abstract

We analyse life-cycle saving decisions when households use simple heuristics, or rules of thumb, rather than solve the underlying intertemporal optimization problem. We simulate life-cycle saving decisions using three simple rules and compute utility losses relative to the solution of the optimization problem. Our simulations suggest that utility losses induced by following simple decision rules are relatively low. Moreover, the two main saving motives reflected by the canonical life-cycle model -long-run consumption smoothing and short-run insurance against income shocks -can be addressed quite well by saving rules that do not require computationally demanding tasks such as backward induction.Keywords: saving, life-cycle models, bounded rationality, rules of thumb JEL classification: D91; E21 * Corresponding author: Joachim Winter, Department of Economics, University of Munich, Ludwigstr.33, D-80539 Munich, Germany. Email: winter@lmu.de. This paper is a substantially revised and extended version of unpublished research by Rodepeter and Winter (1999). We would like to thank Michael Adam, Axel Börsch-Supan, Thomas Crossley, Angelika Eymann, Werner Güth, Silke Januszewski, Ronald Lee, Alexander Ludwig, Annamaria Lusardi, Daniel McFadden, Matthew Rabin, Paul Ruud, Daniel Schunk, the special issue editor (Rachel Griffith) and referees, and participants at numerous seminars and conferences for helpful discussions and comments. We gratefully acknowledge financial support by the Deutsche Forschungsgemeinschaft (DFG) through SFB 504 at the University of Mannheim (Rodepeter and Winter) and through GRK 801 at the University of Munich (Schlafmann). Kathrin Schlafmann also gratefully acknowledges support by LMU Mentoring.

Optimal Rules of Thumb for Consumption and Portfolio Choice

“…They amount to 4-5% of annual consumption from the perspective of a 20-year-old, and they rise to 6-7.5% of annual consumption (depending on education) from the perspective of a 40-yearold. While large, it is worth noting that these losses are actually in the range of the welfare losses found by Winter et al (2012) using more sophisticated rules in a similar life-cycle setting.…”

“…' A handful of previous studies analyse the welfare properties of specific rules of thumb in life-cycle decisions. Winter et al (2012) focus on the performance of several consumption and saving rules of thumb, while Cocco et al (2005) and Gomes et al (2008) consider rules of thumb for portfolio allocation. For different parameterisations and rules, each of these papers calculates a compensating welfare measure that would make a representative individual indifferent between that rule and the solution to the dynamic programming problem.…”

“…Allowing for updating leads to dramatic reductions in the welfare losses relative to those found in previous studies. Finally, the welfare losses in Cocco et al (2005), Gomes et al (2008) and Winter et al (2012) naturally depend on assumptions about individual preferences. This article incorporates parameter uncertainty directly into the welfare calculations and solves for 'optimal' rules of thumb that are robust to preference heterogeneity.…”

“…Previous work has examined the performance of specific rules of thumb for saving (Winter et al, 2012) and asset allocation Gomes et al, 2008). The primary contribution of this article is to move beyond analysing the welfare properties of specific rules to measuring the performance of the best rules within a given class.…”

Optimal Life-Cycle Portfolios for Heterogeneous Workers*

“…22 The third alternative strategy fixes portfolio shares at 1/3 for each financial asset in our model: this mirrors the "1/N " rule of DeMiguel et al (2008), that systematically outperforms several optimal asset allocation strategies in ex post portfolio experiments. The metric used to perform welfare comparisons is the standard consumption-equivalent variation as in Cocco et al (2005) and Winter et al (2012) for each suboptimal asset allocation rule we compute the percentage increase in consumption required by the investor to obtain the same level of expected utility warranted by the optimal life-cycle strategy. 23 Table I shows the welfare losses associated with the three suboptimal asset allocation rules for several combinations of investors' risk aversion, background risk, and correlation between innovations to labour income and stock returns.…”