Mean-variance versus utility maximization revisited: The case of constant relative risk aversion |
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| Institution: | 1. Department of Finance and Business Economics, University of Delhi (South Campus), Benito Juarez Marg, New Delhi, India;2. Refinitiv, India;1. School of Accounting, Information Systems & Supply Chain, RMIT University, 445 Swanston, Melbourne, VIC 3000, Australia;2. School of Accounting, Information Systems & Supply Chain, RMIT University, 445 Swanston Street, Melbourne, VIC 3000, Australia;1. King''s Business School, King''s College London, Level 1, Bush House, 30 Aldwych, London WC2B 4BG, United Kingdom;2. Department of Finance, CUHK Business School, The Chinese University of Hong Kong, Shatin, NT, Hong Kong, China |
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| Abstract: | We examine if mean-variance (M-V) is a good proxy for portfolios based on the Constant Relative Risk Aversion (CRRA) utility function. M-V portfolios are considered good proxies for portfolios from several utility functions which is why they are routinely used in the portfolio theory literature as the benchmark. Our results clearly show this is not the case. Low risk CRRA portfolios are in many cases very different to M-V portfolios, especially with respect to downside risk. If a risk-free asset is available, in many cases, no M-V portfolio is an adequate proxy for CRRA portfolios. The implications of our findings are that: i) M-V portfolios are a poor proxy for investors with CRRA preferences, ii) CRRA portfolios are more suited to investors who care about downside risk than M-V portfolios, and iii) the efficacy of M-V to proxy for utility maximization should be examined more thoroughly. |
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