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Modifying the Mean-Variance Approach to Avoid Violations of Stochastic Dominance

Author

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  • Pavlo R. Blavatskyy

    () (Institute of Public Finance, University of Innsbruck, A-6020 Innsbruck, Austria)

Abstract

The mean-variance approach is an influential theory of decision under risk proposed by Markowitz (Markowitz, H. 1952. Portfolio selection. J. Finance 7(1) 77-91). The mean-variance approach implies violations of first-order stochastic dominance not commonly observed in the data. This paper proposes a new model in the spirit of the classical mean-variance approach without violations of stochastic dominance. The proposed model represents preferences by a functional U(L) - \rho \cdot r(L), where U(L) denotes the expected utility of lottery L, \rho \in [-1, 1] is a subjective constant, and r(L) is the mean absolute (utility) semideviation of lottery L. The model comprises a linear trade-off between expected utility and utility dispersion. The model can accommodate several behavioral regularities such as the Allais paradox and switching behavior in Samuelson's example.

Suggested Citation

  • Pavlo R. Blavatskyy, 2010. "Modifying the Mean-Variance Approach to Avoid Violations of Stochastic Dominance," Management Science, INFORMS, vol. 56(11), pages 2050-2057, November.
  • Handle: RePEc:inm:ormnsc:v:56:y:2010:i:11:p:2050-2057
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    File URL: http://dx.doi.org/10.1287/mnsc.1100.1224
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    References listed on IDEAS

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    1. Bernasconi, Michele, 1994. "Nonlinear Preferences and Two-Stage Lotteries: Theories and Evidence," Economic Journal, Royal Economic Society, vol. 104(422), pages 54-70, January.
    2. Camerer, Colin F & Ho, Teck-Hua, 1994. "Violations of the Betweenness Axiom and Nonlinearity in Probability," Journal of Risk and Uncertainty, Springer, vol. 8(2), pages 167-196, March.
    3. Harry Markowitz, 1952. "Portfolio Selection," Journal of Finance, American Finance Association, vol. 7(1), pages 77-91, March.
    4. Machina, Mark J, 1982. ""Expected Utility" Analysis without the Independence Axiom," Econometrica, Econometric Society, vol. 50(2), pages 277-323, March.
    5. K. Borch, 1969. "A Note on Uncertainty and Indifference Curves," Review of Economic Studies, Oxford University Press, vol. 36(1), pages 1-4.
    6. John Hey, 2001. "Does Repetition Improve Consistency?," Experimental Economics, Springer;Economic Science Association, vol. 4(1), pages 5-54, June.
    Full references (including those not matched with items on IDEAS)

    Citations

    Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
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    Cited by:

    1. Schoch, Daniel, 2017. "Generalised mean-risk preferences," Journal of Economic Theory, Elsevier, vol. 168(C), pages 12-26.
    2. Blavatskyy, Pavlo, 2013. "Which decision theory?," Economics Letters, Elsevier, vol. 120(1), pages 40-44.
    3. Post, Thierry & Kopa, MiloŇ°, 2013. "General linear formulations of stochastic dominance criteria," European Journal of Operational Research, Elsevier, vol. 230(2), pages 321-332.
    4. repec:kap:jrisku:v:54:y:2017:i:2:d:10.1007_s11166-017-9256-0 is not listed on IDEAS
    5. Blavatskyy, Pavlo, 2016. "Probability weighting and L-moments," European Journal of Operational Research, Elsevier, vol. 255(1), pages 103-109.
    6. repec:kap:theord:v:84:y:2018:i:1:d:10.1007_s11238-017-9629-5 is not listed on IDEAS
    7. Blavatskyy, Pavlo R., 2012. "The Troika paradox," Economics Letters, Elsevier, vol. 115(2), pages 236-239.

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