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.
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