Choosing and Using Utility Functions in Forming Portfolios

Geoffrey J. Warren

Financial Analysts Journal, 2019, vol. 75, issue 3, 39-69

Abstract: Utility functions offer a means to encode objectives and preferences in investor portfolios. The functions allow one to place a score on outcomes and then identify optimal portfolios by maximizing utility. The central theme of this article is that utility functions should be tailored to the investor. I discuss how an appropriate function might be chosen and demonstrate concepts for power utility and reference-dependent utility. A modeling approach is presented that may be applied without resorting to dynamic optimization. The selection of utility functions is illustrated for four investor types.Disclosure: The author reports no conflict of interest. Editor’s Note The original version had a typographical error in Figure 4B, which has been corrected in this version. Submitted 1 October 2018Accepted 20 March 2019 by Stephen J. Brown

Date: 2019
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DOI: 10.1080/0015198X.2019.1618109

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