Are the Risk Averse Investors Rational? A Puzzle in the Mean-Varaince Model

Abstract

The mean-variance model has dominated modern finance for a half century, and is the foundation of many modern financial theories, such as the CAPM model. However, by examining the fundamental assumptions in the mean-variance model, this paper finds that there exists an internal inconsistency in the model. It shows that in the framework of the mean-variance model, a risk-averse investor may prefer to pay a higher price for a certain asset. That is, there is a conflict between the non-satiation assumption and the risk-aversion assumption. The paper further indicates the circumstances under which the inconsistency will occur.

Keywords: asset pricing, mean-variance model, portfolio selection, risk aversion

JEL Classification: G0, G1