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American Economic Review: Vol. 95 No. 4 (September 2005)

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Optimal Expectations

Article Citation

Brunnermeier, Markus K., and Jonathan A. Parker. 2005. "Optimal Expectations." American Economic Review, 95(4): 1092-1118.

DOI: 10.1257/0002828054825493

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.

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Authors

Brunnermeier, Markus K.
Parker, Jonathan A.


American Economic Review


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