Optimal Expectations ∗ Markus

This paper introduces a tractable, structural model of subjective beliefs. Forward-looking agents care about expected future utility flows, and hence have higher current felicity if they believe 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 lifetime well-being of an agent. We apply our framework of optimal expectations to three different economic settings. In a portfolio choice problem, agents overestimate the return on their investment and may invest in an asset with negative expected excess return if sufficiently positively skewed. In general equilibrium, agents’ prior beliefs are endogenously heterogeneous, leading to gambling. Finally, 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.