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

Listed author(s):
  • G. Boyle

    (Department of Economics, NUI, Maynooth)

  • D. Conniffe

    (Department of Economics, NUI, Maynooth)

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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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
Handle: RePEc:may:mayecw:n1550305
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  1. J. Tobin, 1958. "Liquidity Preference as Behavior Towards Risk," Review of Economic Studies, Oxford University Press, vol. 25(2), pages 65-86.
  2. Bierwag, G O, 1974. "The Rationale of the Mean-Standard Deviation Analysis: Comment," American Economic Review, American Economic Association, vol. 64(3), pages 431-433, June.
  3. James Tobin, 1969. "Comment on Borch and Feldstein," Review of Economic Studies, Oxford University Press, vol. 36(1), pages 13-14.
  4. Joram Mayshar, 1978. "A Note on Feldstein's Criticism of Mean-Variance Analysis," Review of Economic Studies, Oxford University Press, vol. 45(1), pages 197-199.
  5. 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 354-371, June.
  6. Martin S. Feldstein, 1978. "A Note on Feldstein's Criticism of Mean-Variance Analysis: A Reply," Review of Economic Studies, Oxford University Press, vol. 45(1), pages 201-201.
  7. Ormiston, Michael B & Schlee, Edward E, 2001. "Mean-Variance Preferences and Investor Behaviour," Economic Journal, Royal Economic Society, vol. 111(474), pages 849-861, October.
  8. Meyer, Jack, 1987. "Two-moment Decision Models and Expected Utility Maximization," American Economic Review, American Economic Association, vol. 77(3), pages 421-430, June.
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