When does ‘All Eggs in One Risky Basket’ Make Sense?
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.
|Date of creation:||Mar 2005|
|Date of revision:|
|Contact details of provider:|| Postal: Maynooth, Co. Kildare|
Web page: http://www.maynoothuniversity.ie/economics-finance-and-accounting
More information through EDIRC
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.:
- 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.
- J. Tobin, 1958.
"Liquidity Preference as Behavior Towards Risk,"
Review of Economic Studies,
Oxford University Press, vol. 25(2), pages 65-86.
- 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.
- James Tobin, 1969. "Comment on Borch and Feldstein," Review of Economic Studies, Oxford University Press, vol. 36(1), pages 13-14.
- 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.
- 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.
- Meyer, Jack, 1987. "Two-moment Decision Models and Expected Utility Maximization," American Economic Review, American Economic Association, vol. 77(3), pages 421-30, June.
- 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.
When requesting a correction, please mention this item's handle: RePEc:may:mayecw:n1550305. 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: ()
If references are entirely missing, you can add them using this form.