Complexity and Sophistication

March 2017
Leandro Carvalho and Dan Silverman
Complexity may overwhelm sound decision-making, which has motivated
the development of simple alternatives to solving complex financial
problems. Evidence is lacking, however, on whether people who
struggle with complexity are sophisticated and know when they are
better off opting out. We tested the effects of complexity on financial
choices in a large and diverse sample of Americans, and evaluated the
sophistication of their opting out decisions. With a novel method, we
randomly assigned complexity to portfolio problems. In a second treatment,
we offered a simple option as an alternative to making a portfolio
choice. Complexity leads those with lower skills to more often take
the simple option and, as a result, earn lower returns and make more
dominated choices. Structural estimates of a rational inattention model
indicate that these decisions to opt out are, nevertheless, sophisticated;
they are a response the higher costs of optimizing in complex settings.