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Optimal consumption-portfolio rules with biased beliefs

Author

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  • Hou, Shehong
  • Niu, Yingjie
  • Yang, Jinqiang

Abstract

We extend the model of optimal consumption and asset allocation by incorporating the biased agent beliefs—overconfidence and overextrapolation. It predicts that overconfidence entails overconsumption, lower overconfidence-induced hedging demand and overinvestment in the risky assets, while overextrapolation induces underconsumption, higher overextrapolation-induced hedging demand and underinvestment. Our model provides an alternative explanation for an agent’s mis-consumption/hedging and portfolio misallocation from the perspective of biased beliefs.

Suggested Citation

  • Hou, Shehong & Niu, Yingjie & Yang, Jinqiang, 2018. "Optimal consumption-portfolio rules with biased beliefs," Economics Letters, Elsevier, vol. 173(C), pages 152-157.
    • Handle: RePEc:eee:ecolet:v:173:y:2018:i:c:p:152-157
    DOI: 10.1016/j.econlet.2018.10.003
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    More about this item

    Keywords

    Biased beliefs; Overconfidence; Overextrapolation; Consumption; Asset allocation;
    All these keywords.

    JEL classification:

    • D8 - Microeconomics - - Information, Knowledge, and Uncertainty
    • E2 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment
    • G1 - Financial Economics - - General Financial Markets

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