Optimal Expectation

Markus Brunnermeier and Jonathan Parker

No 4656, CEPR Discussion Papers from C.E.P.R. Discussion Papers

Abstract: This Paper introduces a tractable, structural model of subjective beliefs. Forward-looking agents care about expected future utility flows, and hence have higher current felicity if they believe that better outcomes are more likely. On the other hand, biased expectations lead to poorer decisions and worse realized outcomes on average. Optimal expectations balance these forces by maximizing average felicity. A small bias in beliefs typically leads to first-order gains due to increased anticipatory utility and only to second-order costs due to distorted behaviour. We show that in a portfolio choice problem, agents overestimate the return on their investment and exhibit a preference for skewness. In general equilibrium, agents? prior beliefs are endogenously heterogeneous. Finally, in a consumption-saving problem with stochastic income, agents are both overconfident and overoptimistic.

Keywords: Expectation; Heterogenous beliefs; Belief biases; Consumption; Saving; Portfolio choice; Overconfidence; Gambling (search for similar items in EconPapers)
JEL-codes: D10 D80 E21 G11 G12 (search for similar items in EconPapers)
Date: 2004-10
New Economics Papers: this item is included in nep-evo, nep-fin and nep-mac
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Citations: View citations in EconPapers (17)

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Related works:
Journal Article: Optimal Expectations (2005)
Working Paper: Optimal Expectations (2004)
Working Paper: Optimal Expectations (2004)
Working Paper: Optimal expectations (2002)
Working Paper: Optimal Expectations (2002)
Working Paper: Optimal Expectations (2002)
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