Scribd
Upload
13 views2 pages

Lecture 4 Script

The document introduces mean-variance preferences, which are an important class of preferences in modern portfolio theory. Mean-variance preferences evaluate investments based only on their expected return (mean) and risk (variance), with risk measured as the standard deviation of returns. The model represents investor preferences with indifference curves on a graph plotting risk versus expected return, with higher expected returns and lower risk corresponding to higher utility.

Uploaded by

Ashish Malhotra
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as TXT, PDF, TXT or read online on Scribd
13 views2 pages

Lecture 4 Script

The document introduces mean-variance preferences, which are an important class of preferences in modern portfolio theory. Mean-variance preferences evaluate investments based only on their expected return (mean) and risk (variance), with risk measured as the standard deviation of returns. The model represents investor preferences with indifference curves on a graph plotting risk versus expected return, with higher expected returns and lower risk corresponding to higher utility.

Uploaded by

Ashish Malhotra
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as TXT, PDF, TXT or read online on Scribd

PROFESSOR: Next, we are going to introduce

a special class of preferences called


the mean-variance preferences.
These preferences are very important.
They are at the core of the modern portfolio theory.
They're highly tractable.
And we are going to base a large part
of our discussion of portfolio choice
on this model of preferences.
Let's assume that returns on all investments
are normally distributed.
This means that for any investment
we are willing to consider, the distribution of the returns
is Gaussian with the investment-specific mean
and variance.
Let's call them r bar and sigma squared
for a particular investment under consideration.
An investor, following the expected utility model,
is going to rank investments based
on their expected utility.
Let's compute expected utility of a normally distributed
return.
It's going to be a function of the two moments--
the mean and the variance.
As a result, this investor is going
to evaluate each investment using only these two moments--
the average return, the mean of the investment return,
and the second moment, the variance of the return.
Hence, the name mean-variance preferences.
Variance of returns, or standard deviation,
which is the square root, is the only measure
of risk under this model.
And an investor compares all investments
based on their two key properties, the first two
moments.
We should note that this model of preferences is special.
It applies to many situations.
It produces useful results, but it's not the complete story.
It is, however, an important starting point.
And it is very widely used.
Now, the graph that you see helps
us visualize investor preferences
by plotting the indifference curves in the space of risk
and expected return.
In this case, we will think of risk
as the standard deviation of returns, which is
plotted on the horizontal axis.
And expected returns are on the vertical axis.
The curves that you see, the blues curves,
represent indifference curves corresponding
to a particular set of mean-variance preferences.
What this means is that the investor that you're
thinking about is indifferent between any two
points on the same curve.
Moving in the vertical direction means
increasing the expected return.
Moves us from one indifference curve to the next
and to the next.
So moving up is going to lead to higher
levels of expected utility.
Moving to the left means reducing risk.
This, again, leads to higher levels of expected utility.
When evaluating investment decisions,
an investor with mean-variance preferences
will prefer investments that are represented
by points as far as possible in the Northwest direction based
on the shape of the indifference curves.

You might also like