Non-Standard Preferences

In the real world many facts appear to conflict with the assum ptions of the standard life-cycle model and its main hypotheses. The mental accounting model challenges the assumption that resources are fungible. Substantial evidence produced by psychology, laboratory experiments, and empirical studies points out that people do not make time-consistent decisions, leading to the analysis of time-inconsistent preferences and hyperbolic discounting, a model in which rational agents make time-inconsistent decisions. A third critique is that people are in fact not fully informed about financial opportunities (the equity premium, say, or the virtue of diversification). In this chapter we review the literature on financial sophistication. A final departure from the standard approach explicitly models another important fact of life, namely, that our own choices are affected by the choices of other consumers, owing to social preferences.