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Rationalizing investors’ choices |
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| Institution: | 1. Department of Finance, Grenoble Ecole de Management, 12 Rue Pierre Sémard, 38000 Grenoble, France;2. GGY AXIS, Toronto, Canada;3. Faculty of Economic, Political and Social Sciences and Solvay Business School, Vrije Universiteit Brussel, Belgium;1. Department of Statistics, Forecasting, Mathematics, Faculty of Economics and Business Administration, Babe?-Bolyai University, Cluj Napoca, Romania;2. Department of Economics, University Carlos III of Madrid, Calle Madrid 126, 28903-Getafe (Madrid), Spain;3. Department of Business and Economics and COHERE, University of Southern Denmark, Campusvej 55, 5230 Odense M, Denmark;1. Department of Economics, University of Rochester, Rochester, NY 14627, USA;2. Department of Economics, Vanderbilt University, Nashville, TN 37235, USA;3. College of Administrative Sciences and Economics, Koç University, Sar?yer, Istanbul, 34450, Turkey |
| 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. |
| Keywords: | First-order stochastic dominance Expected utility Utility estimation Law-invariant preferences Decreasing absolute risk aversion Arrow–Pratt risk aversion measure |
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