Optimal Expectation

49 Pages Posted: 3 Dec 2004

See all articles by Jonathan A. Parker

Jonathan A. Parker

Massachusetts Institute of Technology (MIT) - Sloan School of Management; National Bureau of Economic Research (NBER)

Markus K. Brunnermeier

Princeton University - Department of Economics

Date Written: October 2004

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 behavior. 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

JEL Classification: D10, D80, E21, G11, G12

Suggested Citation

Parker, Jonathan A. and Brunnermeier, Markus Konrad, Optimal Expectation (October 2004). Available at SSRN: https://ssrn.com/abstract=629202

Jonathan A. Parker

Massachusetts Institute of Technology (MIT) - Sloan School of Management ( email )

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National Bureau of Economic Research (NBER)

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Markus Konrad Brunnermeier (Contact Author)

Princeton University - Department of Economics ( email )

Bendheim Center for Finance
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HOME PAGE: http://www.princeton.edu/¡­markus

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