Practical Utility, Risk Aversion, and Investment Sizing

Abstract

Concepts of utility and optimizing expected incremental utility are ubiquitous in economics, and also in the academic literature of gambling. However, we have been surprised how little these concepts have impacted real-world finance, despite in many cases providing tools which are both helpful and practical. This seems especially odd given the finance and investment world’s ostensible focus on risk management and risk-adjusted returns. We seek to explain how the concept of utility is both central and practical, and how tools arising from maximizing expected incremental utility are central to the important question of investment sizing.