Knowledge or Patience?

September 25, 2012

One of the most provocative questions is what causes some people to end up with lots of money, and some with very little.

Yawn! you say! How is that provocative?

By Tyler Milligan

It’s provocative causes lead to policy and private market solutions, if you want to treat problems. And the traditionally presumed causes are very different from the ones put forth by behavioral finance. So a recent paper by Justine Hastings and Olivia Mitchell looking at why certain people end up with more or less wealth is provocative because it goes against the common wisdom that the most important lever for improving saving and investment behavior is for financial literacy to be increased. While classic economics says it’s about rationality, behavioral economics says it’s about patience. In their own words:

Two competing explanations for why consumers have trouble with financial decisions are gaining momentum. One is that people are financially illiterate since they lack understanding of simple economic concepts and cannot carry out computations such as computing compound interest, which could cause them to make suboptimal financial decisions. A second is that impatience or present-bias might explain suboptimal financial decisions. That is, some people persistently choose immediate gratification instead of taking advantage of larger long-term payoffs. We use experimental evidence from Chile to explore how these factors appear related to poor financial decisions. Our results show that our measure of impatience is a strong predictor of wealth and investment in health. Financial literacy is also correlated with wealth though it appears to be a weaker predictor of sensitivity to framing in investment decisions. Policymakers interested in enhancing retirement wellbeing would do well to consider the importance of these factors.

To reiterate, **patience is a better predictor of health and wealth outcomes than financial literacy. **This implies that just teaching people about compound interest and diversification may not improve financial outcomes much. You need to change peoples ability to defer gratification, to be more patient. The earliest evidence I’m aware of about this was in the 1960s. You can read more about delayed gratification and life-long outcomes in this great New Yorker piece. But they have now replicated the Mischel Marshmallow experiment, so we get to see what patience and self-control look like in action very early on in life (and very cute).