risk aversion and capital allocation to risky assets

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1、Chapter6:RiskAversionandCapitalAllocationtoRiskyAssetsChapterOpenerPART  IIp.160THEPROCESSOF  constructinganinvestorportfoliocanbeviewedasasequenceoftwosteps:(1)selectingthecompositionofone'sportfolioofriskyassetssuchasstocksandlong-termbonds,and(2)decidinghowmuchtoinvestint

2、hatriskyportfolioversusinasafeassetsuchasshort-termTreasurybills.Obviously,aninvestorcannotdecidehowtoallocateinvestmentfundsbetweentherisk-freeassetandthatriskyportfoliowithoutknowingitsexpectedreturnanddegreeofrisk,soafundamentalpartoftheassetallocationproblemistocharacter

3、izetherisk–returntrade-offforthisportfolio.   Whilethetaskofconstructinganoptimalriskyportfolioistechnicallycomplex,itcanbedelegatedtoaprofessionalbecauseitlargelyentailswell-definedoptimizationtechniques.Incontrast,thedecisionofhowmuchtoinvestinthatportfoliodependsonaninves

4、tor'spersonal preferencesaboutriskversusexpectedreturn,andthereforeitcannoteasilybedelegated.Aswewillseeinthechapteronbehavioralfinance,manyinvestorsstumbleoverthiscardinalstep.Wethereforebeginourjourneyintoportfoliotheorybyestablishingaframeworktoexplorethisfundamentaldecis

5、ion,namely,capitalallocationbetweentherisk-freeandtheriskyportfolio.   Webeginbyintroducingtwothemesinportfoliotheorythatarecenteredonrisk.Thefirstisthetenetthatinvestorswillavoidriskunlesstheycananticipatearewardforengaginginriskyinvestments.Thesecondthemeallowsustoquantify

6、investors'personaltrade-offsbetweenportfolioriskandexpectedreturn.Todothisweintroduceapersonal utilityfunction, whichallowseachinvestortoassignwelfareor“utility”scorestoalternativeportfoliosonthebasisofexpectedreturnandriskandchoosetheportfoliowiththehighestscore.Weelaborate

7、onthehistoricalandempiricalbasisfortheutilitymodelintheappendixtothischapter.   Armedwiththeutilitymodel,wecanresolvetheinvestmentdecisionthatismostconsequentialtoinvestors,thatis,howmuchoftheirwealthtoputatriskforthegreaterexpectedreturnthatcanthusbeachieved.Weassumethatthe

8、constructionoftheriskyportfoliofromtheuniverseofavailableriskyassetshasalre