ON THE IMPORTANCE OF ADAPTING UTILITY FUNCTIONS TO INVESTOR'S

Laura Mariana Cismas () and Roxana Ioan ()
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Laura Mariana Cismas: Economics and Business Modeling Department, Faculty of Economics and Business Administration, West University of Timisoara, Timisoara, Romania,
Roxana Ioan: Economics and Business Modeling Department, Faculty of Economics and Business Administration, West University of Timisoara, Timisoara, Romania,
Authors registered in the RePEc Author Service: Laura-Mariana Cismaș

Annals of Faculty of Economics, 2015, vol. 1, issue 2, 749-757

Abstract: Within the current economic reality, investors are confronted daily with the problem of choosing between more investment options, when acting inside a risky business environment. Thus, the problem of choosing between the existing investment options becomes a multi-criteria problem, within which the investor must take into account not only to maximize the profit, but also to minimize the associated risk. Eventually, the primary aim of any investor is to maximize the utility felt by choosing a certain investment option. We leave from the assumption that an investment option considered to be best in terms of utility by a risk loving investor, will most certainly fail to satisfy a risk averse investor, as the two investors seek different opportunities. In this respect, we come to conclude that a decision making criterion that considers a certain utility function, should adapt the mathematical form of that utility function to fit the user’s attitude towards risk. We consider a decision making criterion to be reliable only if able to maximize the investor’s utility function by taking into account his attitude towards risk. Therefore, we will analyze the decision-making criterion under risky conditions proposed by Daniel Bernoulli by adapting its utility function to the investor’s attitude towards risk. In this respect, we will firstly analyze the characteristics that a utility function should have to be fit for a certain investment profile, in mathematical terms. Following this analysis, we find that different profiles determine different characteristics and, therefore, different utility graphic shapes. Thus, we propose different functions, each of them proper for the investor’s attitude towards risk, in order to expose and use Bernoulli’s criterion. After analyzing each investment profile through its proper utility function, we come to the conclusion that our assumption regarding the difference in utility felt by a risk averse investor and a risk loving investor, was correct, as the best investment option is different for each investment profile.

Keywords: utility function; attitude towards risk; expected utility (search for similar items in EconPapers)
JEL-codes: D81 (search for similar items in EconPapers)
Date: 2015
References: View complete reference list from CitEc
Citations: View citations in EconPapers (1)

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