Optimistic versus Pessimistic--Optimal Judgemental Bias with Reference Point

TL;DR

This paper models how loss-averse individuals choose their reference points for subjective beliefs, balancing optimism and pessimism based on success chances, with implications for investment behaviors.

Contribution

It introduces a reference-dependent model explaining optimal judgmental biases and their effects on decision-making and trading strategies.

Findings

Optimistic investors prefer early information.

Pessimistic investors trade conservatively unless aware of biases.

Bias recognition can lead to more aggressive trading.

Abstract

This paper develops a model of reference-dependent assessment of subjective beliefs in which loss-averse people optimally choose the expectation as the reference point to balance the current felicity from the optimistic anticipation and the future disappointment from the realisation. The choice of over-optimism or over-pessimism depends on the real chance of success and optimistic decision makers prefer receiving early information. In the portfolio choice problem, pessimistic investors tend to trade conservatively, however, they might trade aggressively if they are sophisticated enough to recognise the biases since low expectation can reduce their fear of loss.