Investment Behavior Under Ambiguity: The Case of Pessimistic Decision Makers

Abstract

We define pessimistic, respectively optimistic, investors as CEU (Choquet expected utility) decision makers who update their pessimistic, respectively optimistic, capacities according to a pessimistic (Dempster-Shafer), respectively optimistic, update rule. We demonstrate that pessimistic rather than optimistic investors may strictly prefer investing in an illiquid asset to investing in a liquid asset. Key to our result is the dynamic inconsistency of CEU decision making, implying that a CEU decision maker ex ante prefers a different strategy with respect to prematurely liquidating an uncertain long-term investment project than after learning her liquidity needs. Investing in an illiquid asset therefore serves as a commitment device that guarantees an ex ante favorable outcome. Comparing our results with the hyperbolic time-discounting approach, we further demonstrate that pessimistic decision makers may exhibit a stronger desire for intra-personal commitment than investors with hyperbolic discount functions.

Keywords: Ambiguity, Choquet Expected Utility Theory, Bayesian Updating, Pessimism, Optimism, Hyperbolic Time-Discounting

JEL Classification: D81, G20