Rationalizing Investors Choice
Assuming that agents' preferences satisfy first-order stochastic dominance, we show how the Expected Utility paradigm can rationalize all optimal investment choices: the optimal investment strategy in any behavioral law-invariant (state-independent) setting corresponds to the optimum for an expected utility maximizer with an explicitly derived concave non-decreasing utility function. This result enables us to infer the utility and risk aversion of agents from their investment choice in a non-parametric way. We relate the property of decreasing absolute risk aversion (DARA) to distributional properties of the terminal wealth and of the financial market. Specifically, we show that DARA is equivalent to a demand for a terminal wealth that has more spread than the opposite of the log pricing kernel at the investment horizon.
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
- Dybvig, Philip H, 1988.
"Distributional Analysis of Portfolio Choice,"
The Journal of Business,
University of Chicago Press, vol. 61(3), pages 369-93, July.
- Chateauneuf, A. & Wakker, P., 1998.
"An Axiomatization of Cumulative Prospect Theory for Decision Under Risk,"
Papiers d'Economie MathÃ©matique et Applications
98.51, UniversitÃ© PanthÃ©on-Sorbonne (Paris 1).
- Chateauneuf, Alain & Wakker, Peter, 1999. "An Axiomatization of Cumulative Prospect Theory for Decision under Risk," Journal of Risk and Uncertainty, Springer, vol. 18(2), pages 137-45, August.
- Moshe Levy & Haim Levy, 2002. "Prospect Theory: Much Ado About Nothing?," Management Science, INFORMS, vol. 48(10), pages 1334-1349, October.
- Matthew Polisson & John K.-H. Quah, 2013. "Revealed preference tests under risk and uncertainty," Discussion Papers in Economics 13/24, Department of Economics, University of Leicester.
- R. C. Merton, 1970.
"Optimum Consumption and Portfolio Rules in a Continuous-time Model,"
58, Massachusetts Institute of Technology (MIT), Department of Economics.
- Merton, Robert C., 1971. "Optimum consumption and portfolio rules in a continuous-time model," Journal of Economic Theory, Elsevier, vol. 3(4), pages 373-413, December.
- Fousseni Chabi-Yo & René Garcia & Eric Renault, 2008. "State Dependence Can Explain the Risk Aversion Puzzle," Review of Financial Studies, Society for Financial Studies, vol. 21(2), pages 973-1011, April.
- Dybvig, Philip H. & Wang, Yajun, 2012. "Increases in risk aversion and the distribution of portfolio payoffs," Journal of Economic Theory, Elsevier, vol. 147(3), pages 1222-1246.
- Peleg, Bezalel & Yaari, M E, 1975. "A Price Characterization of Efficient Random Variables," Econometrica, Econometric Society, vol. 43(2), pages 283-92, March.
- Philip H. Dybvig, 1987.
"Inefficient Dynamic Portfolio Strategies or How to Throw Away a Million Dollars in the Stock Market,"
Cowles Foundation Discussion Papers
826R, Cowles Foundation for Research in Economics, Yale University, revised Jan 1988.
- Philip H. Dybvig, 1988. "Inefficient Dynamic Portfolio Strategies or How to Throw Away a Million Dollars in the Stock Market," Review of Financial Studies, Society for Financial Studies, vol. 1(1), pages 67-88.
- Kahneman, Daniel & Tversky, Amos, 1979.
"Prospect Theory: An Analysis of Decision under Risk,"
Econometric Society, vol. 47(2), pages 263-91, March.
- Amos Tversky & Daniel Kahneman, 1979. "Prospect Theory: An Analysis of Decision under Risk," Levine's Working Paper Archive 7656, David K. Levine.
- Dybvig, Philip H & Rogers, L C G, 1997. "Recovery of Preferences from Observed Wealth in a Single Realization," Review of Financial Studies, Society for Financial Studies, vol. 10(1), pages 151-74.
- Nicholas Barberis & Ming Huang, 2007.
"Stocks as Lotteries: The Implications of Probability Weighting for Security Prices,"
NBER Working Papers
12936, National Bureau of Economic Research, Inc.
- Nicholas Barberis & Ming Huang, 2008. "Stocks as Lotteries: The Implications of Probability Weighting for Security Prices," American Economic Review, American Economic Association, vol. 98(5), pages 2066-2100, December.
- De Giorgi, Enrico & Hens, Thorsten, 2005.
"Making Prospect Theory Fit for Finance,"
2005/19, Department of Business and Management Science, Norwegian School of Economics.
- Green, Richard C. & Srivastava, Sanjay, 1986. "Expected utility maximization and demand behavior," Journal of Economic Theory, Elsevier, vol. 38(2), pages 313-323, April.
- Thorsten Hens & Christian Reichlin, 2013. "Three Solutions to the Pricing Kernel Puzzle," Review of Finance, European Finance Association, vol. 17(3), pages 1065-1098.
- Carole Bernard & Franck Moraux & Ludger Rüschendorf & Steven Vanduffel, 2015.
"Optimal payoffs under state-dependent preferences,"
- Carole Bernard & Steven Vanduffel, 2014. "Financial Bounds for Insurance Claims," Journal of Risk & Insurance, The American Risk and Insurance Association, vol. 81(1), pages 27-56, 03.
- Carole Bernard & Jit Seng Chen & Steven Vanduffel, 2014. "Optimal portfolios under worst-case scenarios," Quantitative Finance, Taylor & Francis Journals, vol. 14(4), pages 657-671, April.
- Harry Markowitz, 1952. "Portfolio Selection," Journal of Finance, American Finance Association, vol. 7(1), pages 77-91, 03.
- Birnbaum, Michael H & Navarrete, Juan B, 1998. "Testing Descriptive Utility Theories: Violations of Stochastic Dominance and Cumulative Independence," Journal of Risk and Uncertainty, Springer, vol. 17(1), pages 49-78, October.
- Chen, An & Pelsser, Antoon & Vellekoop, Michel, 2011. "Modeling non-monotone risk aversion using SAHARA utility functions," Journal of Economic Theory, Elsevier, vol. 146(5), pages 2075-2092, September.
- Manel Baucells & Franz H. Heukamp, 2006.
"Stochastic Dominance and Cumulative Prospect Theory,"
INFORMS, vol. 52(9), pages 1409-1423, September.
- Baucells Alibés Manel & Heukamp Franz H., 2007. "Stochastic Dominance and Cumulative Prospect Theory," Working Papers 201061, Fundacion BBVA / BBVA Foundation.
- Mark Bagnoli & Ted Bergstrom, 2005.
"Log-concave probability and its applications,"
Springer;Society for the Advancement of Economic Theory (SAET), vol. 26(2), pages 445-469, 08.
- Haim Levy, 2008. "First Degree Stochastic Dominance Violations: Decision Weights and Bounded Rationality," Economic Journal, Royal Economic Society, vol. 118(528), pages 759-774, 04.
- Chris Starmer, 2000. "Developments in Non-expected Utility Theory: The Hunt for a Descriptive Theory of Choice under Risk," Journal of Economic Literature, American Economic Association, vol. 38(2), pages 332-382, June.
- Tversky, Amos & Kahneman, Daniel, 1992. "Advances in Prospect Theory: Cumulative Representation of Uncertainty," Journal of Risk and Uncertainty, Springer, vol. 5(4), pages 297-323, October.
- Ryan, Matthew J., 2006. "Risk aversion in RDEU," Journal of Mathematical Economics, Elsevier, vol. 42(6), pages 675-697, September.
- Yaari, Menahem E, 1987. "The Dual Theory of Choice under Risk," Econometrica, Econometric Society, vol. 55(1), pages 95-115, January.
- Bernard, Carole & Ghossoub, Mario, 2009. "Static Portfolio Choice under Cumulative Prospect Theory," MPRA Paper 15446, University Library of Munich, Germany.
When requesting a correction, please mention this item's handle: RePEc:arx:papers:1302.4679. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (arXiv administrators)
If references are entirely missing, you can add them using this form.