Expected utility theory; Expected

Utility Theory; risk aversion and

utility functions

Prof. Massimo Guidolin

Portfolio Management

Spring 2016
Outline and objectives
Utility functions

The expected utility theorem and the axioms of choice

Properties of utility functions: non-satiation and risk

preferences

Absolute vs. Relative risk aversion

The effects of the investment horizon

Expected utility theory 2

Generalities
Modelling preferences will help us to exactly pin down the optimal
portfolio selected on the efficient set by each investor
Thus far we have discussed that to solve a portfolio problem we
have to define the opportunity set and a preference function
Under a few assumptions, we focused only on the efficient set
We now turn to defining preferences (for or against risk)
Interestingly, we have appealed already to some properties of such
preferences to build the very efficient set
o For instance, ptfs. inside the minimum variance cloud can be
ignored because for any given level of risk, other portfolios have a
higher mean; for a given mean ptf. return, other ptfs. carry lower risk
Consider the following three investments:

Expected utility theory 3

Utility functions
A utility function of wealth converts wealth outcomes in subjectively
perceived value, i.e., investors satistifaction or happiness
An intuitive approach consists of converting the outcomes in the
value that these carry to investors
o Of course, if the outcomes were the same as monetary payoffs, then
value and outcome may correspond
o However, it is easy to imagine reasons for paying more attention to
the lowest outcomes in the worse states over the average/best ones
Suppose the investor uses the following utility function to assign
values to outcomes:
which is a quadratic function
A utility function of wealth (money) is a cardinal object that
converts wealth outcomes in subjectively perceived value, i.e.,
investors satisfaction or happiness
Because different outcomes come with an associated probability
distributions, different investments will be indexed by their
expected utility Expected utility theory 4
Utility functions
The expected utility of the three investments are computed as each
of the outcomes times the value of probabilities

Thus, an investor with a quadratic utility function, would select

investment A.
Cardinal utility functions of this type (i.e., functions that attribute a
meaning to the U(W) happiness possess a key property
Expected utility theory 5
Utility functions
Utility functions are unique up to monotone increasing linear
transformations
This means that A + bv(W) with b > 0 will lead to the same
portfolio choices as v(W)
o E.g., assume that preferences are V(W) = 2 + 12W (3/10)W2
o The only difference between the two functions is the addition of the
number 2 and the multiplication by 3
o Thus, the value of each outcome would be increased by two times the
probability of the outcome plus 3 times wealth multiplied by the
probability of the outcome
o But if some choice gives a wealth W* such that
U(W) = 4W (1/10)W2 > U(W*) = 4W* (1/10)(W*)2 then
V(W) = 2 + 3W (3/10)W2 = 2 + 3U(W) >
V(W*) = 2 + 4W* (3/10)(W*)2 = 2 + 3U(W*)
If the investor obeys certain postulates, then the choice of
preferred investment, using the expected utility theorem, is
identical to the choice made by examining the investment directly
Expected utility theory 6
The expected utility theorem and the axioms of choice
Utility functions are unique up to monotone increasing linear
transformations
The expected utility theorem (EUT) can be developed from a set of
postulates concerning investors behavior
If an investor acts in according to these axioms, her behavior is
indistinguishable from taking decisions on the basis of the EUT
The axioms are:
Comparability. An investor can state a preference among all
alternative outcomes; thus, if the investor has a choice of outcome
A or B, a preference for A to be or of B to A can be stated or
indifference btw. them can be expressed
Transitivity. If an investor prefers A to B and B to C then she will
have to also prefer A to C
o I.e., investors are consistent in their ranking of outcomes
o Although this seems reasonable, considerable experimental evidence
displays stark cases of violations
Expected utility theory 7
The expected utility theorem and the axioms of choice
o The difficulty occurs because some situations are sufficiently
complex that the investor is unable to understand all of the
implications of their decisions
o In experimental situations, when the presence of irrational
intransitivies are pointed out, subjects tend to revise their decisions
Independence. Consider the certain prospects X and Y and assume
the investor is the investor is indifferent btw. them; independence
implies that the investor will also be indifferent btw:
X with probabilty P and Z with probability 1 - P, and
Y with probabilty P and Z with probability 1 - P,
o If a person is indifferent btw. winning a Panda or a 500, then she will
also be indifferent between a lottery ticket for 10 euros that gave a 1
in 500 chance of winning a Panda and a different lottery ticket for 10
euros that gave a 1 in 500 chance of winning a 500
Certainty Equivalent (continuity). For every gamble, there is a
value (called certainty equivalent, CER) that makes the investor
indifferent btw. the gamble and the CER
Expected utility theory 8
The expected utility theorem and the axioms of choice
Using these axioms, we can derive the expected utility theorem
o Consider a security G with two possible outcomes

o Let C be the amount that would make the investor indifferent btw.
gamble G and receiving C, the CER; clearly C depends on the prob. h
o From axiom 4, C must exist; if we vary h, then a different value of C
would be appropriate
o If we varied h over a large number of values
and then plotted all values of h versus C, we
may have the following diagram
o The investor's preference curve separates
combinations of C and h for which the
investor prefers the risky gamble from
points where the investor prefers the
certain amount
o Points above the curve are points where the gamble is preferred and
points below the curve are points where the CER is preferred
Expected utility theory 9
The expected utility theorem and the axioms of choice
o Now consider a portfolio of securities S1 with N possible outcomes:

o Each Wi is a known payoff and since Cis exist for all Wis, S1 is equiva-
lent to

o Since for every Ci there exists

an equivalent lottery, we can
represent an equivalent
lottery as you can see on the right
o If the investor declares btw. the Cis
and each lottery, then S1 S2
Expected utility theory 10
The expected utility theorem and the axioms of choice
o For instance, if outcome i occurs, if the investor selects S1
then Ci is received; if the investor selects S2, then the
investor receives b with prob. hi, and 0 with prob. 1 - hi
o However investor has indicated in the construction
of the preference curve an indifference btw. Ci and
this lottery; but Wi is equal to Ci so that the investor is
indifferent btw. Wi and this lottery
o Thus, security 2 is equivalent to security 1
o From axiom 3 the investor does not change preference simply
because the alternatives are part of a lottery
o As the picture shows, S2 has only 2 possible outcomes, b and 0
o We can equivalently write S2 has payoff b with prob.
and 0 with prob. 1 -
o Utilizing this technique with any portfolio, that
can be therefore reduced to two outcomes, b
and 0, with known probabilities
o How do we choose between these portfolios?
We only need to consider the probability of receveing b
Expected utility theory
11
The expected utility theorem and the axioms of choice
o Define ; then if HK > HL, security K is to be preferred to
security L
o This leads directly to the EUT: earlier we have replaced Wi with Ci, to
which hi was associated
o Call the function that relates Wi to hi a utility function, hi = U(Wi) and
note that Hi = iPihi = iPiU(Wi)
o But iPiU(Wi) is simply expected utility and ranking securities on
the basis of Hi is equivalent to using expected utility
Having an investor make choices between a series of simple
investments, we can attempt to determine the weighting (utility)
function that the investor is implicitly using
Applying this weighting function to more complicated
investments, we should be able to determine which one the
investor would choose
o A number of brokerage firms have developed programs to extract
the utility function by confronting investors with simple choices
o These have not been particularly successful
Expected utility theory
12
Properties of utility functions: non satiation
Standard utility functions (of terminal wealth) are monotone
increasing and represent non-satiated preferences
Many investors do not obey all the rationality postulates when
faced with a series of choice situations, even though they may find
the underlying principles perfectly reasonable
Investors, when faced with more complicated choice situations,
encounter aspects of the problem that were not of concern to them
in the simple choice situations
What are the properties we expect of reasonable utility functions?
The first restriction placed on a utility function is that it be
consistent with more being preferred to less
This attribute, aka nonsatiation, simply says that the utility of
more (W + 1) dollars is higher than the utility of less (W) dollars
Equivalently, more wealth is always preferred to less wealth
If utility increases as wealth increases, then the first derivative of
utility, with respect to wealth, is positive, U(W) >0
Expected utility theory 13
Properties of utility functions: risk aversion
A fair gamble is a gamble priced at its expected value; a risk-averse
investor will always reject a fair gamble in favor of its mean value
o Earlier lectures discussed opportunity sets in terms of returns rather
than wealth, but there is no substantive difference as Wt+1 = (1 +
RPt+1)Wt
The second restriction concerns preferences for risk
Risk aversion, risk neutrality, and risk-seeking behaviors are all
defined relative to a fair gambe
A fair gamble is one that it is priced at its expected value, e.g.,
(1/2)(2)+(1/2)(0) = 1 in the example below
o The position of the investor may be improved or hurt by taking the
investment, but the expectation is of no change
Against this background, risk aversion means that an investor will
always reject a fair gamble

Expected utility theory 14

Properties of utility functions: risk aversion
o In our example the investor prefers $1 for sure to the chances to win
$2 with a prob.
Mathematically, risk aversion implies that the U() function is
concave; if U() is differentiable, then U() < 0
o If an investor prefers not to invest, then the expected utility of not
investing must exceed the one of investing, or
U(1) > (1/2)U(2) + (1/2)U(0)
o Multiplying both sides by 2 and re-arranging,
U(1) U(0) > U(2) - U(1)
which means that for the same unit increase in wealth, the utility
function changes less and less as the initial wealth to which the
increase applies grows
o Functions that exhbit this property are said to be concave
Economically, risk aversion means that an investor will reject a fair
gamble because the dis-utility of the loss is greater than the utility
of the gain in the case of a good outcome
Risk-seeking behavior obtains in the opposite case: the investor
always likes a fair gamble 15
Expected utility theory
Properties of utility functions: risk neutrality and seeking
A risk-loving investor will always accept a fair gamble over its mean
value; a risk-neutral investor is indifferent to fair gambles
Mathematically, risk-seeking preferences imply that the U()
function is convex; if U() is differentiable, then U() > 0
o If an investor prefers to take the fair gamble, then the expected utility
of investing must exceed the one of not investing, or
U(1) < (1/2)U(2) + (1/2)U(0)
o Multiplying both sides by 2 and re-arranging,
U(1) U(0) < U(2) - U(1)
which means that for the same unit increase in wealth, the utility
function changes more and more as the initial wealth to which the
increase applies grows
Risk neutrality means that an investor is indifferent to whether or
not a fair gambe should be undertaken
Risk neutrality implies a linear utility function; ; if U() is
differentiable, then U() = 0
These conditions are summarized in the following table
Expected utility theory 16
Properties of utility functions: risk preferences

The figures shows preference functions exhibiting alternative

properties with respect to risk aversion
The leftmost figure shows utility functions in the wealth space, the
rightmost in the mean-variance space

1= Risk-seeking
2= Risk-neutral
3 = Risk-averse

Expected utility theory 17

Properties of utility functions: absolute risk aversion
Investors who can state their feelings toward a fair gamble can
significantly reduce the set of risky investments they consider
o E.g., risk-averse investors must consider only the efficient frontier
when choosing among alternative portfolios
The third property of utility functions that is sometimes presumed
is an assumption about how the investor's preferences change
with a change in wealth
If the investor's wealth increases, will more or less of that wealth
be invested in risky assets?
If the investor increases the amount invested in risky assets as
wealth increases, then the investor is said to exhibit decreasing
absolute risk aversion
If the investor's investment in risky assets is unchanged as wealth
changes, then she is said to exhibit constant absolute risk aversion
Finally, if the investor invests fewer dollars in risky assets as
wealth increases, then she is said to exhibit increasing absolute
risk aversion Expected utility theory 18
Properties of utility functions: absolute risk aversion
The index that can be used to measure an investors absolute risk
aversion is:

Then A(W) is an appropriate measure of how absolute risk

aversion changes w.r.t. changes in wealth
The table below summarizes the relevant properties
The final characteristic that is used to restrict the investor's utility
function is how the percentage of wealth invested in risky assets
changes as wealth changes

Expected utility theory 19

Properties of utility functions: relative risk aversion
The coefficient of absolute (relative) risk aversion governs how the
total (relative, percentage) amount invested in risky assets changes as
wealth changes
When the percentage invested in all risky assets does no change as
wealth changes, the investors behavior is said to be characterized
by constant relative risk aversion
Relative risk aversion is related to absolute risk aversion but RRA
refers to the change in the percentage investment in risky assets as
wealth changes, ARA to dollar amounts invested in risky assets

Expected utility theory 20

Quadratic utility functions and their limitations
Quadratic utility functions may be satiated and imply problematically
increasing absolute and relative risk aversion coefficients
While there is general agreement that most investors exhibit
decreasing absolute risk aversion, there is much less agreement
concerning relative risk aversion
Often people assume constant relative risk aversion
The justification for this, however, is often one of convenience
rather than belief about descriptive accuracy
We are now ready to inquire about the properties of the quadratic
utility function previously postulated, U(W) = W bW2
o U(W) = 1 2bW, U(W) = -2b, A(W) = 2b/(1 - 2bW),
o This investor is satiated iff 1 2bW >0, or W < 1/(2b) = bliss point
o Below the bliss point, A(W) > 0
but it is monotone increasing
o Below the bliss point, because
R(W) = WA(W), clearly RRA
increases as W increases 21
Expected utility theory
Logarithmic utility functions
Logarithmic utility functions imply a decreasing absolute risk
aversion, constant relative risk aversion, and are non-satiated
In spite of its problems, quadratic utility takes a special place in
mean-variance analysis because it is perfectly consistent with it
However, considerable literature has shown that a quadratic utility
function may provide an excellent approximation to another, more
robust utility function, the logarithmic one: U(W) = lnW
o U(W) = 1/W, U(W) = -1/W2, A(W) = 1/W, R(W) = WA(W) = 1
o Therefore this utility function exhibits decreasing absolute and
constant relative risk aversion
o See the Appendix for details on the approximation argument

The utility functions reviewed so far are, in general, based upon

investor choice over a single-time horizon
In reality, investors confront a multiperiod choice problem
Any asset allocation chosen today can be undone tomorrow
Expected utility theory 22
The effects of the investment horizon under log utility
Let us return to the log-utility function
Suppose a log-utility investor with $1000 faces a multiperiod
investment opportunity, she has the choice to invest in a risky
asset for two periods, one period, or not to invest at all
The risky asset is forecast to either double or halve in value each
period, with equal probability
The expected utility calculation for the risky investment in the first
period would be
U(one period) = (1/2)ln($2000) + (1/2)ln($500) = 6.9077
If she simply held cash, the utility would be ln($1000) = 6.9077
Thus, this investor is indifferent between investing for one period
or not investing at all
$1000 is called the certainty equivalent for the risky investment
because it is the certain value that will make you indifferent
between taking and not taking a gamble
Expected utility theory 23
The effects of the investment horizon under log utility
Under constant relative risk aversion preferences and with un-
correlated (IID) risky returns, the investment horizon doesnt matter
Under the same conditions for a second investment period, the
log-utility investor will also be indifferent
Calculating the expected utility for the four potential outcomes in
period 2 (i.e., two doublings in a row, two halvings in a row, a
doubling and then a halving, and a halving then a doubling), the
expected utility is
U(two period) = (1/4)ln($4000) + (1/2)ln($1000) +
+(1/4)ln($250) = 6.9077
Thus, for the log-utility investor (for all classes of utility functions
that display constant relative risk aversion for multiplicative
investments), the horizon of the investment will not affect choices
One important exception to this rule is when the returns of the
risky asset are correlated over time
o When, for example, asset prices tend to go down after a rise, or up
after a fall Expected utility theory 24
The effects of the investment horizon under log utility
In this case risky investments are more attractive (less risky) in
the long run than they in the short run
The proportion invested in risky assets will increase as the
horizon gets longer
Obviously this is just a limit result, a sort of paradox
When asset returns are dependent over time, the horizon will
affect optimal portfolio choices
If investors don't exhibit time indifference, how do they act?
It turns out that investors who have some tolerance for very large
losses may be willing to invest in risky assets over long horizons,
but not necessarily over short horizons
This increased willingness to invest in the risky asset as the
investment horizon grows suggests that the asset allocation choice
of many investors can depend on how long they expect keep their
money invested before using it for retirement, education, or to
meet other future liabilities
Expected utility theory 25
Myopic portfolio choice: canonical case
The risky share should equal the risk premium, divided by condi-
tional variance times the coefficient capturing aversion to risk
Suppose the conditional mean of a single risky portfolio is Et[rt+1]
and the conditional variance is 2t
The investor only cares for conditional mean and conditional
variance,

The problem has the classical solution:

The portfolio share in the risky asset should equal the expected
excess return, or risk premium, divided by conditional variance
times the coefficient that represents aversion to variance
Mean-variance portfolio choice 26
Myopic portfolio choice: canonical case
If we define the Sharpe ratio of the risk asset as:

then the MV solution to the problem can be written as:

The corresponding risk premium and Sharpe ratio for
the optimal portfolio are as follows:

Hence all portfolios have the same Sharpe ratio because they all
contain the same risky asset in greater or smaller amount
Mean-variance portfolio choice 27
Myopic portfolio choice: multivariate case
These results extend straightforwardly to the case where there are
many risky assets
o We define the portfolio return in the same manner except that we use
boldfaced letters to denote vectors and matrices
o Rt+1 is now a vector of risky returns with N elements.
o It has conditional mean vector Et[Rt+1] and conditional covariance
matrixt Vart[Rt+1]
o We want to find the optimal allocation wt Vector of 1s
repeated N times
The maximization problem now becomes

with solution

Mean-variance portfolio choice 28

Myopic portfolio choice: multivariate case
A straightforward generalization of the single risky asset case
o The single risk premium return is replaced by the vector of risk
premia and the reciprocal of variance is replaced by t-1, the inverse
of the covariance matrix of returns
o Investors preferences enter the solution only through the scalar
Thus investors differ only in the overall scale of their risky asset
portfolio, not in the composition of that portfolio
o This is the two-fund, separation theorem of Tobin (1958) again
The results extend to the case where there is no completely riskless
asset: we call still define a benchmark asset with return R0,t
We now develop portfolio choice results under the assumption that
investors have power utility and that asset returns are lognormal
We apply a result about the expectation of a log-normal random
variable X:

Mean-variance portfolio choice 29

The power utility log-normal case
o The log is a concave function and therefore the mean of the log of a
random variable X is smaller than the log of the mean, and the
difference is increasing in the variability of X
Assume that the return on an investors portfolio is lognormal, so
that next-period wealth is lognormal
Under of power utility, the objective is

Maximizing this expectation is equivalent to maximizing the log of

the expectation, and the scale factor 1/(1 - ) can be omitted
Because next-period wealth is lognormal, we can apply the earlier
result to rewrite the objective as
(*)

The standard budget constraint can be rewritten in log form:

Mean-variance portfolio choice 30

The power utility log-normal case
Under power utility and log-normal portfolio returns (hence, terminal
wealth), a mean-variance result applies under appropriate definition
of the mean of portfolio returns relevant to the portfolio choice
Dividing (*) by (1 - ) and using the new constraint, we have:

Just as in mean-variance analysis, the investor trades-off mean

against variance in portfolio returns
Notice that this can be further transformed as:

so that

Mean-variance portfolio choice 31

The power utility log-normal case
o The appropriate mean is the simple return, or arithmetic mean
return, and the investor trades off the log of this mean linearly
against the variance of the log return
o When = 1, under log utility, the investor selects the portfolio with
the highest available log return (the "growth optimal portfolio)
o When > 1, the investor seeks a safe portfolio by penalizing the
variance of ln(1 + Rpt+1)
o When < 1, the investor actually seeks a riskier portfolio because a
higher variance, with the same mean log return, corresponds to a
higher mean simple return
o The case = 1 is the boundary where these two opposing
considerations balance out exactly
Problem: To proceed further, we would need to relate the log ptf.
return to the log returns on the underlying assets
But while the simple return on a ptf. is a linear combination of the
simple returns on the risky and riskless assets, the log ptf. return is
not the same as a linear combination of logs
Mean-variance portfolio choice 32
Summary
In this lecture we have learned a number of things
1. That preferences for bundles of goods and services may be
represented by utility functions
2. That this result, under appropriate conditions extends to the case
of uncertainty, when the Expected Utility Theorem holds
3. That under the EUT, the notion of being risk averse is intuitive
and corresponds to concavity of the utility function, U()
4. That degree of aversion to risk may be measured through the
coefficients of absolute and relative risk aversion
5. That CARA and CRRA preferences induce special results when it
comes to comparative statistics of portfolio choice
6. That mean-variance preferences and portfolio decisions may also
represent approximation to more classical and better behaved
utility functions

Expected utility theory 33

Appendix: the link between expected quadratic utility
and mean-variance wealth preferences

Expected utility theory 34