Rationalizing Investors Choice

TL;DR

This paper demonstrates that under certain preference assumptions, all optimal investment choices can be explained by a specific expected utility framework, allowing for non-parametric inference of utility and risk aversion.

Contribution

It provides a novel characterization of optimal investment strategies as expected utility maximizers with explicitly derived utility functions, linking risk aversion to market and wealth distribution properties.

Findings

Optimal investment choices can be rationalized by a derived utility function.

Decreasing absolute risk aversion relates to the spread of terminal wealth and market properties.

The approach allows non-parametric inference of agents' utility and risk preferences.

Abstract

Assuming that agents' preferences satisfy first-order stochastic dominance, we show how the Expected Utility paradigm can rationalize all optimal investment choices: the optimal investment strategy in any behavioral law-invariant (state-independent) setting corresponds to the optimum for an expected utility maximizer with an explicitly derived concave non-decreasing utility function. This result enables us to infer the utility and risk aversion of agents from their investment choice in a non-parametric way. We relate the property of decreasing absolute risk aversion (DARA) to distributional properties of the terminal wealth and of the financial market. Specifically, we show that DARA is equivalent to a demand for a terminal wealth that has more spread than the opposite of the log pricing kernel at the investment horizon.