How Wishful Thinking Can Hurt Retirement
Two economists examine how wishful thinking can lead to reduced saving and can generate asset bubbles.
Do wishful thinkers have less saved for retirement/?
It’s entirely possible, according to a new working paper from the National Bureau of Economic Research.
The paper — by Andrew Caplin, a professor of economics at New York University, and John Leahy, a professor of macroeconomics at the University of Michigan — examines the economic implications of wishful thinking.
According to the paper, wishful thinking involves “choosing to believe that the truth is what one would like the truth to be.”
For example, as shown in a 1968 study, bettors at a race track placed higher odds on their preferred horse when interviewed after placing their bets than bettors did when interviewed while in line waiting to place their bets.
“Wishful thinking is strongest when outcomes are uncertain and payoff differences are large,” the paper explains. “Such situations might plausibly include choices that are made infrequently so that the [person] lacks experience. Planning for retirement is an example.”
In particular, the paper finds that wishful thinking can lead to reduced saving.
To determine this, the economists used a model with a risk-free bond and idiosyncratic income risk to determine how wishful thinkers and objective thinkers may differ in their savings.
“Wishful thinkers tend to be optimistic regarding their future labor income,” the paper states. “This leads them to consume more and save less, and therefore accumulate less wealth than do those who are objective.”
The paper notes that in this particular case the wishful thinking affects only the expectation of labor because the bond return is fixed.
“In a model with risky assets, wishful thinkers can be optimistic about asset returns,” according to the report. “Depending on the relative importance of income and substitution effects, saving could rise.”
Other situations where it’s likely to see wishful thinking at its strongest are those in which it is difficult to know the value of an option — such as the purchase of a house — or there are multiple theories on the table and very little evidence to distinguish between them, as is often the case with asset bubbles, according to the paper.
The paper looks at wishful thinkers’ role in asset bubbles.
As an example, the paper looks at the introduction of a new and uncertain technology — such as railroads, information technology, or cryptocurrency — and argues that the wishful thinkers will bid its price above its fundamental value.
“Initially wishful thinkers will make up only a small portion of the demand for the asset because they tend to be less wealthy than objective [people],” the paper explains.
Then a period of good news increases interest in the new asset, and this initial success of the asset may cause wishful thinkers’ role to grow with time. This happens partly because the wishful thinkers will hold a greater share of the new asset in their portfolios.
“As the importance of the wishful thinkers grows, they bid the price of the asset above fundamentals,” the paper explains. “As the price rises the importance of the wishful thinkers continues to grow, as objective [observers] see the market as overvalued.”
At the top of the market, when an objective observer would question the potential of the technology to be transformative, wishful thinkers will tend to downplay bad news.
“Wishful thinking, however, is not magical thinking.,” according to the paper. “Eventually even optimists must admit that the asset is only mildly successful.”
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