The Impact of Optimistic and Pessimistic Preferences on Decision Making

20 Pages Posted: 6 Aug 2013

See all articles by Soosung Hwang

Soosung Hwang

Sungkyunkwan University - Department of Economics

Stephen E. Satchell

University of Cambridge - Faculty of Economics and Politics

Date Written: August 5, 2013

Abstract

The notion of optimism or pessimism is defined in the psychology literature in terms of forecasting where the term is used more generally than in statistics. Here we use the theory of loss aversion combined with Bayesian forecasting to propose rather precise definitions of optimism and pessimism. Put simply, optimists are those who condition their Bayesian state probabilities on optimistic forecasts whilst pessimists condition their Bayesian state probabilities on pessimistic forecasts. This simple structure leads to closed-form results in asset allocation problems which can be seen as a solution of more general dichotomous problems. Our results with loss aversion utility show that a slightly optimistic (or pessimistic) preference would have a huge impact on the optimal asset allocation.

Keywords: Loss Aversion, Bayesian Rule, Relative Optimism, Asset Allocation

JEL Classification: D03, G02

Suggested Citation

Hwang, Soosung and Satchell, Stephen E., The Impact of Optimistic and Pessimistic Preferences on Decision Making (August 5, 2013). Available at SSRN: https://ssrn.com/abstract=2306023 or http://dx.doi.org/10.2139/ssrn.2306023

Soosung Hwang (Contact Author)

Sungkyunkwan University - Department of Economics ( email )

25-2 Sungkyunkwan-ro
Jongno-Gu
110-745 Seoul
+82 (0)2 760 0489 (Phone)
+82 (0)2 744 5717 (Fax)

Stephen E. Satchell

University of Cambridge - Faculty of Economics and Politics ( email )

Austin Robinson Building
Sidgwick Avenue
Cambridge, CB3 9DD
United Kingdom
44 (0)1223 335213 (Phone)
44 (0)1223 335475 (Fax)

HOME PAGE: http://www.econ.cam.ac.uk/faculty/satchell/index.h

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