Optimal Expectation
49 Pages Posted: 3 Dec 2004
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: Suggested Citation
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