DP4656 Optimal Expectation

Author(s): Markus K Brunnermeier, Jonathan A Parker
Publication Date: October 2004
Keyword(s): belief biases, consumption, expectation, gambling, heterogenous beliefs, overconfidence, portfolio choice, saving
JEL(s): D10, D80, E21, G11, G12
Programme Areas: International Macroeconomics, Financial Economics
Link to this Page: cepr.org/active/publications/discussion_papers/dp.php?dpno=4656

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.