Affective Decision-Making: A Theory of Optimism-Bias

Abstract

Optimism-bias is inconsistent with the independence of decision weights and payo¤s found in models of choice under risk, such as expected utility theory and prospect theory. Hence, to explain the evidence suggesting that agents are optimistically biased, we propose an alternative model of risky choice, a¤ective decision-making, where decision weights-which we label a¤ective or perceived risk-are endogenized. A¤ective decision making (ADM) is a strategic model of choice under risk, where we posit two cognitive processes: the "rational" and the "emotional" processes. The two processes interact in a simultaneous-move intrapersonal potential game, and observed choice is the result of a pure strategy Nash equilibrium in this potential game. We show that regular ADM potential games have an odd number of locally unique pure strategy Nash equilibria, and demonstrate this …nding for a¤ective decision making in insurance markets. We prove that ADM potential games are refutable, by axiomatizing the ADM potential maximizers.

Testing Models of Belief Bias: An Experiment

“…The results suggest that people hold optimistically biased beliefs, and comparative statics indicate that these beliefs are not constrained by increasing the costs of making inaccurate judgments. In fact, the results support the theory of Bracha and Brown (2012), as observed bias is increasing in the size of incentive payments for accuracy.JEL classification: C91, D03, D80, D81, D83, D84. …”

“…By varying financial prizes in outcomes, as well as incentive payments for accuracy, the experiment is able to distinguish between two leading theories of optimistic belief formation that differ in their assumptions about how such beliefs are constrained. The optimal expectations theory of Brunnermeier and Parker (2005) models beliefs as being constrained through the future costs of holding incorrect beliefs, while the affective decision making model of Bracha and Brown (2012) argues that beliefs are constrained by mental costs of distorting reality. The results suggest that people hold optimistically biased beliefs, and comparative statics indicate that these beliefs are not constrained by increasing the costs of making inaccurate judgments.…”

“…As individual optimism strays further from the "truth", it becomes increasingly costly to internally justify holding these beliefs. In the theory of affective decision making, Bracha and Brown (2012) (henceforth BB) model a strategic game between an emotional process and a rational process, that emphasizes these direct costs of distorting reality.…”

Deception and Self-Deception

“…Bodner and Prelec (2002) and Bénabou and Tirole (2011) show how in the presence of uncertainty about one's own preferences, people use actions to influence their own beliefs about their deep characteristics. Bracha and Brown (2012) and Mayraz (2012) provide models where affective influences color risk perceptions, leading to suboptimal decisions. Testing these ideas empirically, Coutts (2015) and Mayraz (2012) find evidence that raising the cost of mistaken beliefs does not reduce overoptimism, a finding that is inconsistent with the theory by Brunnermeier and Parker (2005).…”

Review of Behavioral Biases - An Individual Equity Investor Perspective.

“…That is, optimism was only the expectation of a favorable output without paying attention to how the output will be achieved with the given quality of resources. Bracha and Brown (2012) explained that optimism played an important role when faced with risky situations and the information about the situation was also known, that is, endogenous ambiguity. An optimistic individual would view the ambiguity as advantageous and hence was being ambiguity-seeking whereas a pessimistic individual would view it as disadvantageous and hence was being ambiguity-averse.…”