Choosing and Using Utility Functions in Forming Portfolios

Financial Analysts Journal, Volume 75, Issue 3, 2019, pp. 39-69

Posted: 25 Jul 2018 Last revised: 14 Aug 2019

See all articles by Geoff Warren

Geoff Warren

Australian National University (ANU) - Research School of Finance, Actuarial Studies and Statistics

Date Written: July 1, 2019

Abstract

Utility functions offer a means to encode objectives and preferences in investor portfolios. The functions allow one to place a score on outcomes and then identify optimal portfolios by maximizing utility. The central theme of this article is that utility functions should be tailored to the investor. I discuss how an appropriate function might be chosen and demonstrate concepts for power utility and reference-dependent utility. A modeling approach is presented that may be applied without resorting to dynamic optimization. The selection of utility functions is illustrated for four investor types.

Keywords: utility function, portfolio construction, investment horizon

JEL Classification: G11, G23

Suggested Citation

Warren, Geoffrey J., Choosing and Using Utility Functions in Forming Portfolios (July 1, 2019). Financial Analysts Journal, Volume 75, Issue 3, 2019, pp. 39-69. Available at SSRN: https://ssrn.com/abstract=3207865 or http://dx.doi.org/10.2139/ssrn.3207865

Geoffrey J. Warren (Contact Author)

Australian National University (ANU) - Research School of Finance, Actuarial Studies and Statistics ( email )

CBE Building 26C
Kingsley Sreet, Acton
Canberra, ACT 0200
Australia

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