Modifying the Mean-Variance Approach to Avoid Violations of Stochastic Dominance
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.
Volume (Year): 56 (2010)
Issue (Month): 11 (November)
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- Harry Markowitz, 1952. "Portfolio Selection," Journal of Finance, American Finance Association, vol. 7(1), pages 77-91, 03.
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