Portfolio Management and

Wealth Planning
RISK AVERSION AND UTILITY FUNCTION

Doç. Dr. Ayben Koy

 Risk Aversion and Capital Allocation to Risky Assets
 1) Selecting the composition of one’s portfolio of risky assets such as stocks and long-term
bonds

 2) deciding how much to invest in that risky portfolio versus in a safe asset such as short-term
Treasury bills
 Risk Averse Investors (A > 0)

 Risk Neutral Investors (A = 0)

 Risk Lover Investors (A < 0)

 Risk Averse Investors

 reject investment portfolios that are fair games or worse

 Are willing to consider only risk-free or speculative prospects with positive risk premium
 Penalizes the expexted rate of return of a risky portfolio by a certain percentage to account for
the risk involved

 The greater the risk, the larger the penalty

An investor considers three alternative risky portfolios:
 Risk free rate : 5%

 Which portfolio would he choose?

Risk Premium % Expected Return Risk (SD) %

%
L (low risk) 2 7 5
M (medium risk) 4 9 10
H (high risk) 8 13 24
 Utility function
 Each investor have got utility scores to alternative portfolios based on expected return and risk.

 With the utility model, we can resolve the investment desicion that is how much of their wealth
to put at risk for the greater expected return that can thus be achieved.

 Using the expected return and risk parameters in the utility model yields the optimal allocation
of capital between the risky portfolio and risk free asset.
  Higher utility values are assigned to portfolios with more attractive risk and return profiles
 Higher utility scores ---- higher expected returns
 Lower scores --- higher volatility


 Consider 3 different degrees of risk aversion: A1 A2 A3

 A1 = 2 Risk Premium % Expected Return Risk (SD) %

%
 A2 = 3.5
L (low risk) 2 7 5
 A3 = 5 M (medium risk) 4 9 10
H (high risk) 8 13 24
  

Risk Expected Risk (SD) U U U

Premiu Return % % A1 A2 A3
m%
L (low risk) 2 7 5
M (medium 4 9 10
risk)
H (high risk) 8 13 24
  

Risk Expected Risk (SD) U U U

Premiu Return % % A1 A2 A3
m%
L (low risk) 2 7 5 0.0675 0.0656 0.06375
M (medium 4 9 10 0.08 0.0725 0.065
risk)
H (high risk) 8 13 24 0.072 0.0292 -0.014
 CFA QUESTION
Investment Expected return Standart deviation
1 0.12 0.30
2 0.15 0.50
3 0.21 0.16
4 0.24 0.21

Which investment would you select if you were risk averse with A = 4?

Based on utility formula, which investment would you select if you were risk neutral?
 CFA QUESTION
Investment Expected return Standart deviation
1 0.12 0.30 U= -0,06
2 0.15 0.50 U = -0,35
3 0.21 0.16 U = 0,1588
4 0.24 0.21 U = 0,1518

Which investment would you select if you were risk averse with A = 4? (3rd)

Based on utility formula, which investment would you select if you were risk neutral? (4th)
 Risk Neutral Investors (A = 0)

 The level of risk is irrelavant for risk neutral investors.

 For this investor a portfolio’s equivalent rate is simply it’s rate of return
 Risk Lover Investors (A < 0)

 A risk lover is willing to engage in fair games and gambles.

 This investor adjusts the expected return upward to take into account the «fun» of confronting
the prospect’s risk.
 Reference
 Bodie, Z., Kane, A., & Marcus, A. J. Essentials of Investments 8th Edition. McGraw-Hill.