Expected Utility Theory

TL;DRAbstract

Investors generally face many prospects available in the capital market to choose from (e.g., stocks, bonds, portfolios of assets, and mutual funds), where only one portfolio (which may contain one or many assets) of these prospects is selected. To be able to make systematic choices, one needs a method for ranking the various investments. Finding the appropriate method for ranking the various prospects is not an easy task. Moreover, many methods are available, each with its pros and cons, and researchers generally disagree on the appropriate ranking method to be employed. This chapter is devoted to the expected utility ranking method and to the existing criticisms of this method. In subsequent chapters, we show the relation of the Mean-Variance (M-V) analysis and the Capital Asset Pricing Model (CAPM) to the Expected Utility Theory (EUT), and we also show how deviations from the expected utility paradigm affect the M-V and the CAPM.

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