3
$\begingroup$

I'm currently trying to wrap my head around modern portfolio theory and would love a simple explanation on how it differs from a marginal utility model (if at all).

As I am understanding it, MPT allows you to create a portfolio of assets in optimal quantities at a given risk factor. However, isn't this basically the same as judging the marginal risk return of each asset and then funding each to its relative "risk return" (e.g. fund Asset A until marginal return is less than asset B, then fund asset B, fund asset B until marginal return is less than C, then fund C).

$\endgroup$
2
$\begingroup$

Welcome to EC.SE! Hopefully this will help.

I don't think this characterization is correct. These are not opposing theories. Modern portfolio theory is based on the idea that people choose portfolios to maximize their utility. After that, it depends on the specification of utility. As a simple example, a person with a quadratic utility function will choose a portfolio that is mean-variance efficient. The particular portfolio allocation will depend on the risk-aversion parameter in the utility function.

For examples discussed in other questions on the site, see Calculating the optimal portfolio for an investor with quadratic utility and Portfolio choice problem of a CARA investor with n risky assets.

$\endgroup$
0
$\begingroup$

Harry Markowitz invented modern portfolio theory. If agents have quadratic utility or asset returns follow jointly normally distributed random variables, then his process describes how to construct optimal portfolios given the expected returns and forward-looking covariance of asset returns. If those are not your preferences and assets returns follow a different process (as we think they do), then you need a dynamic programming approach (like this) for optimal portfolio construction.

$\endgroup$

Your Answer

By clicking “Post Your Answer”, you agree to our terms of service, privacy policy and cookie policy

Not the answer you're looking for? Browse other questions tagged or ask your own question.