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Optimal Beliefs, Asset Prices, and the Preference for Skewed Returns

33 Pages Posted: 30 Mar 2007  

Markus K. Brunnermeier

Princeton University - Department of Economics

Christian Gollier

University of Toulouse 1 - Industrial Economic Institute (IDEI); CESifo (Center for Economic Studies and Ifo Institute)

Jonathan A. Parker

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

Multiple version iconThere are 3 versions of this paper

Date Written: February 2007

Abstract

Human beings want to believe that good outcomes in the future are more likely, but also want to make good decisions that increase average outcomes in the future. We consider a general equilibrium model with complete markets and show that when investors hold beliefs that optimally balance these two incentives, portfolio holdings and asset prices match six observed patterns: (i) because the cost of biased beliefs are typically second-order, investors typically hold biased assessments of probabilities and so are not perfectly diversified according to objective metrics; (ii) because the costs of biased beliefs temper these biases, the utility cost of the lack of diversification are limited; (iii) because there is a complementarity between believing a state more likely and purchasing more of the asset that pays off in that state, investors over-invest in only one Arrow-Debreu security and smooth their consumption well across the remaining states; (iv) because different households can settle on different states to be optimistic about, optimal portfolios of ex ante identical investors can be heterogeneous; (v) because low-price and low-probability states are the cheapest states to buy consumption in, overoptimism about these states distorts consumption the least in the rest of the states, so that investors tend to overinvest in the most skewed securities; (vi) finally, because investors with optimal expectations have higher demand for more skewed assets, ceteris paribus, more skewed asset can have lower average returns.

Keywords: portfolio choice, asset pricing, expectations, heterogeneous beliefs, optimal

JEL Classification: D1, D8, G11, G12

Suggested Citation

Brunnermeier, Markus K. and Gollier, Christian and Parker, Jonathan A., Optimal Beliefs, Asset Prices, and the Preference for Skewed Returns (February 2007). Available at SSRN: https://ssrn.com/abstract=976962 or http://dx.doi.org/10.2139/ssrn.976962

Markus Konrad Brunnermeier

Princeton University - Department of Economics ( email )

Bendheim Center for Finance
Princeton, NJ
United States
609-258-4050 (Phone)
609-258-0771 (Fax)

HOME PAGE: http://www.princeton.edu/¡­markus

Christian Gollier

CESifo (Center for Economic Studies and Ifo Institute) ( email )

Poschinger Str. 5
Munich, DE-81679
Germany

University of Toulouse 1 - Industrial Economic Institute (IDEI) ( email )

Manufacture des Tabacs
21 Allee de Brienne bat. F
Toulouse Cedex, F-31000
France
+33 61 12 86 30 (Phone)
+33 61 12 86 37 (Fax)

Jonathan A. Parker (Contact Author)

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

100 Main Street
E62-416
Cambridge, MA
United States
617-253-7218 (Phone)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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