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Optimal Expectations

Markus Brunnermeier () and Jonathan Parker

American Economic Review, 2005, vol. 95, issue 4, 1092-1118

Abstract: Forward-looking agents care about expected future utility flows, and hence have higher current felicity if they are optimistic. This paper studies utility-based biases in beliefs by supposing that beliefs maximize average felicity, optimally balancing this benefit of optimism against the costs of worse decision making. A small optimistic bias in beliefs typically leads to first-order gains in anticipatory utility and only second-order costs in realized outcomes. In a portfolio choice example, investors overestimate their return and exhibit a preference for skewness; in general equilibrium, investors' prior beliefs are endogenously heterogeneous. In a consumption-saving example, consumers are both overconfident and overoptimistic.

Date: 2005
Note: DOI: 10.1257/0002828054825493
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Working Paper: Optimal Expectations (2002) Downloads
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