30 Pages Posted: 2 Feb 2014 Last revised: 1 May 2015
Date Written: January 31, 2014
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.
Keywords: First-order stochastic dominance, Expected Utility, Utility Estimation, Risk Aversion, Law-invariant Preferences, Decreasing Absolute Risk Aversion, Arrow-Pratt risk aversion measure
JEL Classification: G11, D03, D11, G02
Suggested Citation: Suggested Citation
Bernard, Carole and Chen, Jit Seng and Vanduffel, Steven, Rationalizing Investors Choice (January 31, 2014). Journal of Mathematical Economics, Forthcoming. Available at SSRN: https://ssrn.com/abstract=2388929 or http://dx.doi.org/10.2139/ssrn.2388929