Intertemporal Portfolio Choice with Incorrect Beliefs and Aversion to Surprise

Ani Guerdjikova () and John Quiggin
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Ani Guerdjikova: GAEL - Laboratoire d'Economie Appliquée de Grenoble - Grenoble INP - Institut polytechnique de Grenoble - Grenoble Institute of Technology - INRA - Institut National de la Recherche Agronomique - CNRS - Centre National de la Recherche Scientifique - UGA [2016-2019] - Université Grenoble Alpes [2016-2019]

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Abstract: We consider the impact of partial awareness in the form of a restriction of the state space. We show that when a decision maker is aware of his unawareness, his perception of the state space can be represented by a partition. Such a decision maker behaves as if he restricts his portfolio choice to a subset of the available assets with payo§s measurable w.r.t. his awareness partition and thus avoids "surprises". Such a heuristic allows the partially aware agent to survive, but only if his beliefs on his awareness partition are at least as close to the truth as the beliefs of a more aware agent with a Öner partition. Introducing a second heuristic, aversion to unforeseen unfavorable surprises, as in Grant and Quiggin (2015), allows us to establish survival of partially aware agents, regardless of whether their beliefs are correct. This heuristic implies that the agent holds a minimal number of bonds in his portfolio. Asset prices in such an economy reáect the potentially incorrect beliefs of the fully aware agents and replicate the well-known equity premium puzzle.

Date: 2018-06-14
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Published in 2018 Risk, Uncertainty and Decision Conference, Jun 2018, Heidelberg, Germany

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