Optimal expectations

Markus Brunnermeier and Jonathan Parker

LSE Research Online Documents on Economics from London School of Economics and Political Science, LSE Library

Abstract: This paper introduces a tractable, structural model of subjective beliefs. Since agents that plan for the future care about expected future utility flows, current felicity can be increased by believing that better outcomes are more likely. On the other hand, expectations that are biased towards optimism worsen decision making, leading to poorer realized outcomes on average. Optimal expectations balance these forces by maximizing the total well-being of an agent over time. We apply our framework of optimal expectations to three different economic settings. In a portfolio choice problem, agents overestimate the return of their investment and underdiversify. In general equilibrium, agents' prior beliefs are endogenously heterogeneous, leading to gambling. Second, in a consumption-saving problem with stochastic income, agents are both overconfident and overoptimistic, and consume more than implied by rational beliefs early in life. Third, in choosing when to undertake a single task with an uncertain cost, agents exhibit several features of procrastination, including regret, inter-temporal preference reversal, and a greater readiness to accept commitment.

Keywords: expectation formation; beliefs; overconfidence; wishful thinking; procrastination; gambling (search for similar items in EconPapers)
JEL-codes: D1 D8 E21 G11 G12 (search for similar items in EconPapers)
Pages: 49 pages
Date: 2002-12
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Downloads: (external link)
http://eprints.lse.ac.uk/24954/ Open access version. (application/pdf)

Related works:
Journal Article: Optimal Expectations (2005)
Working Paper: Optimal Expectation (2004)
Working Paper: Optimal Expectations (2004)
Working Paper: Optimal Expectations (2004)
Working Paper: Optimal Expectations (2002)
Working Paper: Optimal Expectations (2002)
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Persistent link: https://EconPapers.repec.org/RePEc:ehl:lserod:24954

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