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When does ‘All Eggs in One Risky Basket’ Make Sense?

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  • G. Boyle

    (Department of Economics, NUI, Maynooth)

  • D. Conniffe

    (Department of Economics, NUI, Maynooth)

Abstract

In an important paper comparing expected utility and mean-variance analysis, Feldstein (1969) examined a simple portfolio problem involving just two assets, one riskless and one risky. He concluded there could easily be ‘plunging’, that is, investment in the risky asset alone. His background assumptions were that the risky asset’s yield was log normally distributed and that the investor’s attitude to risk was expressible by a logarithmic utility. We look at how conclusions are affected by choice of distribution and utility function. While conclusions can depend on choice of distribution, they are remarkably robust to choice within the range of plausible positive distributions. In contrast, conclusions are sensitive to choice of utility function and we find the key determinant to be how much the investor’s relative risk aversion differs from unity and in what direction. Based on historical stock market returns, our analysis implies that the prevalence of diversification that is observed is consistent with a relative risk aversion coefficient of about 2.5.

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Bibliographic Info

Paper provided by Department of Economics, Finance and Accounting, National University of Ireland - Maynooth in its series Economics, Finance and Accounting Department Working Paper Series with number n1550305.

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Length: 13 pages
Date of creation: Mar 2005
Date of revision:
Handle: RePEc:may:mayecw:n1550305

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Phone: 353-1-7083728
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  1. Feldstein, Martin S, 1978. "A Note on Feldstein's Criticism of Mean-Variance Analysis: A Reply," Review of Economic Studies, Wiley Blackwell, vol. 45(1), pages 201, February.
  2. Mayshar, Joram, 1978. "A Note on Feldstein's Criticism of Mean-Variance Analysis," Review of Economic Studies, Wiley Blackwell, vol. 45(1), pages 197-99, February.
  3. Ormiston, Michael B & Schlee, Edward E, 2001. "Mean-Variance Preferences and Investor Behaviour," Economic Journal, Royal Economic Society, vol. 111(474), pages 849-61, October.
  4. Meyer, Jack, 1987. "Two-moment Decision Models and Expected Utility Maximization," American Economic Review, American Economic Association, vol. 77(3), pages 421-30, June.
  5. James Tobin, 1956. "Liquidity Preference as Behavior Towards Risk," Cowles Foundation Discussion Papers 14, Cowles Foundation for Research in Economics, Yale University.
  6. Tobin, James, 1969. "Comment on Borch and Feldstein," Review of Economic Studies, Wiley Blackwell, vol. 36(105), pages 13-14, January.
  7. Bierwag, G O, 1974. "The Rationale of the Mean-Standard Deviation Analysis: Comment," American Economic Review, American Economic Association, vol. 64(3), pages 431-33, June.
  8. Tsiang, S C, 1972. "The Rationale of the Mean-Standard Deviation Analysis, Skewness Preference, and the Demand for Money," American Economic Review, American Economic Association, vol. 62(3), pages 354-71, June.
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Cited by:
  1. Trino-Manuel Niguez & Ivan Paya & David Peel & Javier Perote, 2013. "Higher-order moments in the theory of diversification and portfolio composition," Working Papers 18297128, Lancaster University Management School, Economics Department.

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