Choosing and Using Utility Functions in Forming Portfolios

Abstract

Utility functions offer a means to encode objectives and preferences in investor portfolios. The functions allow one to place a score on outcomes and then identify optimal portfolios by maximizing utility. The central theme of this article is that utility functions should be tailored to the investor. I discuss how an appropriate function might be chosen and demonstrate concepts for power utility and reference-dependent utility. A modeling approach is presented that may be applied without resorting to dynamic optimization. The selection of utility functions is illustrated for four investor types.