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Optimal expectations

Brunnermeier, Markus K. and Parker, Jonathan A. (2002) Optimal expectations. Discussion paper, 434. Financial Markets Group, London School of Economics and Political Science, London, UK.

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Identification Number: 434

Abstract

This paper introduces a tractable, structural model of subjective beliefs. Since agents that plan for the future care about expected future utility flows, current felicity can be increased by believing that better outcomes are more likely. On the other hand, expectations that are biased towards optimism worsen decision making, leading to poorer realized outcomes on average. Optimal expectations balance these forces by maximizing the total well-being of an agent over time. We apply our framework of optimal expectations to three different economic settings. In a portfolio choice problem, agents overestimate the return of their investment and underdiversify. In general equilibrium, agents' prior beliefs are endogenously heterogeneous, leading to gambling. Second, in a consumption-saving problem with stochastic income, agents are both overconfident and overoptimistic, and consume more than implied by rational beliefs early in life. Third, in choosing when to undertake a single task with an uncertain cost, agents exhibit several features of procrastination, including regret, inter-temporal preference reversal, and a greater readiness to accept commitment.

Item Type: Monograph (Discussion Paper)
Official URL: http://fmg.lse.ac.uk
Additional Information: © 2002 The Authors
Subjects: H Social Sciences > HG Finance
H Social Sciences > HB Economic Theory
Sets: Research centres and groups > Financial Markets Group (FMG)
Collections > Economists Online
Collections > LSE Financial Markets Group (FMG) Working Papers
Date Deposited: 20 Aug 2009 16:10
Last Modified: 27 Feb 2014 15:36
URI: http://eprints.lse.ac.uk/id/eprint/24954

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