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Bounded rationality as a source of loss aversion and optimism: A study of psychological adaptation under incomplete information

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  • Yao, Jing
  • Li, Duan

Abstract

We develop a formal model to investigate the implications of bounded rationality for the origin and structure of loss aversion and optimism in marketplaces. Based on Simon's original description, we explicitly model bounded rationality as a decision mechanism that captures incomplete information, psychological adaptation, and rational behavior. We find that the endogenous loss aversion and optimism emerge when the degree of information incompleteness reaches a certain threshold, and both grow to be more prominent when information becomes sparser. Our results highlight that the psychological biases could be expected to take advantage of perceived information incompleteness in terms of value creation.

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  • Yao, Jing & Li, Duan, 2013. "Bounded rationality as a source of loss aversion and optimism: A study of psychological adaptation under incomplete information," Journal of Economic Dynamics and Control, Elsevier, vol. 37(1), pages 18-31.
    • Handle: RePEc:eee:dyncon:v:37:y:2013:i:1:p:18-31
    DOI: 10.1016/j.jedc.2012.07.002
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    More about this item

    Keywords

    Loss aversion; Optimism; Bounded rationality; Incomplete information; Dynamic portfolio choice;
    All these keywords.

    JEL classification:

    • D03 - Microeconomics - - General - - - Behavioral Microeconomics: Underlying Principles
    • D8 - Microeconomics - - Information, Knowledge, and Uncertainty
    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions

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