Citation

Discussion Paper Details

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Title: Optimal Expectation

Author(s): Markus K Brunnermeier and Jonathan A Parker

Publication Date: October 2004

Keyword(s): belief biases, consumption, expectation, gambling, heterogenous beliefs, overconfidence, portfolio choice and saving

Programme Area(s): Financial Economics and International Macroeconomics

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.

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Bibliographic Reference

Brunnermeier, M and Parker, J. 2004. 'Optimal Expectation'. London, Centre for Economic Policy Research. https://cepr.org/active/publications/discussion_papers/dp.php?dpno=4656