Optimal Choice and Beliefs with Ex Ante Savoring and Ex Post Disappointment

We propose a new decision criterion under risk in which individuals extract both utility from anticipatory feelings ex ante and disutility from disappointment ex post. The decision maker chooses his degree of optimism, given that more optimism raises both the utility of ex ante feelings and the risk of disappointment ex post. We characterize the optimal beliefs and the preferences under risk generated by this mental process and apply this criterion to a simple portfolio choice/insurance problem. We show that these preferences are compatible with first-degree and second-degree stochastic dominance and yield a preference for early resolution of uncertainty. Furthermore, they are consistent with observed violations of the independence axiom, such as the preference reversal in the Allais paradox, and predict that the decision maker takes on less risk compared to an expected utility maximizer. Our decision criterion can thus help explain the equity premium puzzle and the preference for low deductibles in insurance contracts.

[1]  M. Rabin.  Risk Aversion and Expected Utility Theory: A Calibration Theorem , 2000 .

[2]  M. Rothschild,et al.  Increasing risk: I. A definition , 1970 .

[3]  Clotilde Napp,et al.  Are Risk Averse Agents More Optimistic? A Bayesian Estimation Approach , 2007 .

[4]  Mark J. Machina,et al.  Temporal risk and the nature of induced preferences , 1984 .

[5]  J. Shepperd,et al.  Bracing for the Worst: Severity, Testing, and Feedback Timing as Moderators of the Optimistic Bias , 1998 .

[6]  Miles S. Kimball,et al.  Standard Risk Aversion , 1991 .

[7]  David E. Bell,et al.  Disappointment in Decision Making Under Uncertainty , 1985, Oper. Res..

[8]  M. Machina.  Choice under Uncertainty: Problems Solved and Unsolved , 1987 .

[9]  I. Ritov,et al.  Decision Affect Theory: Emotional Reactions to the Outcomes of Risky Options , 1997 .

[10]  N. Wikler,et al.  The Economic Consequences , 1985 .

[11]  Mark J. Machina,et al.  Non-Expected Utility and The Robustness of the Classical Insurance Paradigm , 1995 .

[12]  Charles A. Holt,et al.  Estimating Risk Preferences from Deductible Choice , 2007 .

[13]  Marcel Zeelenberg,et al.  Blessed are those who expect nothing: Lowering expectations as a way of avoiding disappointment , 2003 .

[14]  P. Carroll,et al.  Forsaking Optimism , 2006 .

[15]  Larry G. Epstein,et al.  Substitution, Risk Aversion, and the Temporal Behavior of Consumption and Asset Returns: A Theoretical Framework , 1989 .

[16]  Christian Gollier,et al.  The Comparative Statics of Changes in Risk Revisited , 1995 .

[17]  Louis Eeckhoudt,et al.  A Good Sign for Multivariate Risk Taking , 2006, Manag. Sci..

[18]  George A. Akerlof,et al.  The Economic Consequences of Cognitive Dissonance , 1982 .

[19]  M. Machina.  "Expected Utility" Analysis without the Independence Axiom , 1982 .

[20]  Charles H. Whiteman,et al.  Habit formation: a resolution of the equity premium puzzle? , 2002 .

[21]  Justin R. Sydnor.  Sweating the Small Stuff : Demand for Low Deductibles in Homeowners Insurance , 2006 .

[22]  George M. Constantinides,et al.  Habit Formation: A Resolution of the Equity Premium Puzzle , 1990, Journal of Political Economy.

[23]  Markus K. Brunnermeier,et al.  Optimal Expectations , 2004 .

[24]  Lawrence L. Schkade,et al.  The Selection of an Optimal Deductible for a Given Insurance Policy , 1966 .

[25]  M. Rothschild,et al.  Increasing risk II: Its economic consequences , 1971 .

[26]  J. Shepperd,et al.  The Affective Consequences of Expected and Unexpected Outcomes , 2002, Psychological science.

[27]  J. Ouellette,et al.  Abandoning Unrealistic Optimism: Performance Estimates and the Temporal Proximity of Self-Relevant Feedback , 1996 .

[28]  Justin R. Sydnor.  Over)insuring Modest Risks , 2010 .

[29]  Ravi Bansal,et al.  Risks for the Long Run: A Potential Resolution of Asset Pricing Puzzles , 2000 .

[30]  Liran Einav,et al.  Estimating Risk Preferences from Deductible Choice , 2005 .

[31]  Miles S. Kimball.  Precautionary Saving in the Small and in the Large , 1989 .

[32]  Faruk Gul.  A Theory of Disappointment Aversion , 1991 .

[33]  Evan L. Porteus,et al.  Temporal von neumann-morgenstern and induced preferences , 1979 .

[34]  Joel Slemrod,et al.  Denial of Death and Economic Behavior , 2005 .

[35]  C. Gollier.  Optimal Illusions and Decisions Under Risk , 2005, SSRN Electronic Journal.

[36]  N. Aplin.  PSYCHOLOGICAL EXPECTED UTILITY THEORY AND ANTICIPATORY FEELINGS * A , 1997 .

[37]  M. Rabin,et al.  A Model of Reference-Dependent Preferences , 2006 .

[38]  M. Rabin,et al.  Reference-Dependent Risk Attitudes , 2007 .

[39]  Ilana Ritov,et al.  The affective costs of overconfidence , 2004 .