The effect of Risk Aversion on the Dynamic Selection of the Optimum Portfolio

Abstract

Economic agents are constantly making decisions to maximize their expected utilities while accepting some risks. The question is that, how the efficient portfolio of the assets in a specific level of risk is formed to maximize the individual’s utility? To model the behavior of decision maker, economists and financial mathematicians consider both the variables which affect individual’s decision making behaviour, and the methods to include real world uncertainties. In the model presented in this paper the decision maker chooses between two types of assets: risky and risk-free. The returns on these two types are different and the utility of the decision maker is a function of his wealth (consisting of his initial wealth and the returns of his portfolio of the assets). The comparison between the results of financial modeling with decision-making theories under uncertainty within microeconomic literature reveals the impacts of three factors: degree of risk-aversion, relative return of assets and volatility of risky assets prices, on optimum portfolio allocation.

Keywords

• risk aversion
• return
• risk
• expected utility