Optimal Illusions and Decisions under Risk

We examine a static one-risk-free-one-risky asset portfolio choice when the investor’s well-being is affected by the anticipatory feelings associated to potential capital gains and losses. These feelings can be manipulated by the choice of subjective beliefs on the distribution of returns. However, the bias of these endogenous subjective beliefs induces the choice of a portfolio that is suboptimal with respect to the objective expected utility of final wealth. We characterize the structure of these optimal beliefs. We first show that optimal subjective beliefs must be degenerated with only two possible returns. Moreover, under some weak conditions on the utility function, these two atoms are at the lower and upper bounds of the objectively feasible returns. When the intensity of anticipatory feelings is small, the formation of beliefs must be biased in favor of optimism, which implies an increase in the equilibrium demand for the risky asset. We also show that the optimal beliefs are approximately independent of the investor’s degree of risk aversion.anticipatory feelings, portfolio choice, overconfidence, positive thinking, endogenous beliefs

Optimal Portfolio Management for Individual Pension Plans

We explore the various arguments for and against the recommendation that younger households should invest a larger share of their pension wealth in risky assets. The ability of young agents to compensate their financial losses by saving more during their career provides the strongest argument in favour of younger people investing more aggressively in the stock market. Meanreversion in stock returns yields another argument. However, the uninsurability of the risky human capital goes in the opposite direction, together with the imperfect knowledge that young investors have about the distribution of asset returns.dynamic portfolio choice, pension plan, retirement, time horizon