Risk and utility in portfolio optimization

Morrel H. Cohen and Vincent D. Natoli

Physica A: Statistical Mechanics and its Applications, 2003, vol. 324, issue 1, 81-88

Abstract: Modern portfolio theory (MPT) addresses the problem of determining the optimum allocation of investment resources among a set of candidate assets. In the original mean-variance approach of Markowitz, volatility is taken as a proxy for risk, conflating uncertainty with risk. There have been many subsequent attempts to alleviate that weakness which, typically, combine utility and risk. We present here a modification of MPT based on the inclusion of separate risk and utility criteria. We define risk as the probability of failure to meet a pre-established investment goal. We define utility as the expectation of a utility function with positive and decreasing marginal value as a function of yield. The emphasis throughout is on long investment horizons for which risk-free assets do not exist. Analytic results are presented for a Gaussian probability distribution. Risk-utility relations are explored via empirical stock-price data, and an illustrative portfolio is optimized using the empirical data.

Keywords: Portfolio; Risk utility; Mean-variance; Finance (search for similar items in EconPapers)
Date: 2003
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Citations: View citations in EconPapers (4)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:phsmap:v:324:y:2003:i:1:p:81-88

DOI: 10.1016/S0378-4371(02)01957-X

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