The Geneva Papers on Risk and Insurance Theory, 29: 137–144, 2004

c 2004 The Geneva Association

Portfolio Selection with Quadratic Utility Revisited

TIMOTHY MATHEWS [email protected]
Department of Economics, California State University-Northridge, 18111 Nordhoff St., Northridge,
CA 91330-8374

Received December 10, 2002; Revised May 15, 2003

Abstract
Considering a simple portfolio selection problem by agents with quadratic utility, an apparently counterintuitive
outcome results. When such a choice is over two assets that can be ordered in terms of riskiness, an agent that
is more risk averse may optimally invest a larger portion of wealth in the riskier asset. It is shown that such an
outcome is not counterintuitive, since for the portfolios from which agents optimally choose, a larger proportion
of investment in the riskier asset leads to a less risky portfolio.

Key words: portfolio selection, choice under uncertainty

JEL Classification No.: G11, D8

1. Introduction

Ross [1981] criticized the standard definition of more risk averse by highlighting some
apparently counterintuitive choices made by agents that can be ordered in terms of degree
of risk aversion. One of Ross’ examples showed that in a simple portfolio selection problem,
an individual with a higher degree of absolute risk aversion may choose to invest more in a
riskier asset (using his new definition of an asset being riskier).1 Ross proposed a stronger
concept of more risk averse and showed that such a counterintuitive outcome cannot occur
when his new concept of more risk averse is applied (again, using his new definition of an
asset being riskier).
Hadar and Seo [1990] examine the implications of Ross’ definition of more risk averse
in situations in which a choice is over two assets that can be compared using the tradi-
tional definition of riskier. They show that Ross’ stronger definition of more risk averse
may not necessarily rule out the counterintuitive outcomes it was intended to. One of the
examples considered by Hadar and Seo is a simple portfolio selection problem in which
an agent must decide upon the proportion of wealth to invest in each of two risky assets.
Comparing the optimal choice of agents with quadratic Bernoulli utility functions, they ar-
rive at the seemingly counterintuitive conclusion that the more risk averse agent optimally
chooses to invest more in the riskier asset. It is argued here that this outcome, which was
labelled counterintuitive by both Ross and Hadar and Seo, is not so counterintuitive after
all.
138 MATHEWS

2. Simple portfolio selection problem

Consider an economic agent making a decision under uncertainty. The level of utility
from a payoff of x is obtained by evaluating the Bernoulli utility function, u(·), at x.
Given a distribution of payoffs F(x), the utility of the agent is given by the von-Neumann-
Morgenstern utility function


U (F(x)) = u(x) d F(x).

Suppose an agent must choose optimal proportions of a fixed amount of wealth to invest
in two risky assets X and Y . Further, suppose that Y is riskier than X in that X second order
stochastic dominates Y and has a higher mean than Y.
Hadar and Seo consider such a choice by agents with Bernoulli utility functions of the
form

u i (w) = w − ki w 2

where ki > 0 and 2k1 i exceeds the largest possible realization of w. Considering two
u

(x) u

(x)
agents A and B, A is more risk averse than B in the Arrow-Pratt sense if − u
A (x) ≥ − u
B (x)
A B
for all x (with strict inequality almost everywhere). In the current context, this is
satisfied if and only if k A > k B . A is more

risk averse than B as defined by Ross if
u (x) u
(y)
for all x and y there exists λ > 0 such that u

A (x) ≥ λ ≥ u
A (y) . For agents with different
B B
preferences, this condition is again satisfied in the current context if and only if k A > k B .
Let α denote the proportion invested in asset Y . That is, the portfolio of an agent is given
by the random variable Wα = αY + (1 − α)X with α ∈ [0, 1]. Denote the value of α
characterizing the optimal portfolio of agent i by αi∗ .

3. A counterintuitive outcome?

As a function of α, the von-Neumann-Morgenstern utility for agent i is

 
Ui (α) = E(Wα ) − ki E Wα2 .
Supposing that each agent optimally chooses to invest a positive amount in each asset, the
optimal portfolio choices for agents A and B are such that

U A
(α ∗A ) = E(Y − X ) − 2k A E(W A∗ (Y − X )) = 0

and

U B
(α ∗B ) = E(Y − X ) − 2k B E(W B∗ (Y − X )) = 0

where W A∗ = α ∗A Y + (1 − α ∗A )X and W B∗ = α ∗B Y + (1 − α ∗B )X .
PORTFOLIO SELECTION WITH QUADRATIC UTILITY REVISITED 139

As shown by Hadar and Seo, these conditions imply α ∗A > α ∗B . That is, they arrive at the
apparently counterintuitive result that the more risk averse agent will choose to invest more
in the riskier asset.2 Thus, Hadar and Seo illustrate that Ross’ definition of more risk averse
is not strong enough to rule out such a seemingly counterintuitive result when the standard
definition of riskier is used.
It has been shown by Rothschild and Stiglitz [1970] that the preferences of an expected
utility maximizing agent over different distributions of wealth cannot always be consistently
stated as preferences over mean and variance alone. This can only be done if restrictive
assumptions are made about either the Bernoulli utility function of the agent or the specific
class of distributions from which the agent must choose. Borch [1969] and Baron [1977]
have shown that for any arbitrary payoff distribution, preferences can be stated over mean
and variance alone only if an agent has a quadratic Bernoulli utility function.
Others have attempted to show consistency of mean-variance analysis and expected utility
analysis for restricted classes of random variables. Meyer [1987] proves such consistency
for situations in which all risks under consideration belong to a common two-parameter
family, the elements of which differ from one another by only location and scale. It should
be noted that the class of random variables resulting from the portfolio selection problem
considered here (with two risky assets) need not satisfy the location and scale parameter
condition identified by Meyer.3 Bigelow [1993] provides a necessary and sufficient condition
for consistency of mean-variance analysis and expected utility analysis. Bigelow defines
a class of random variables to be normalized risk comparable if all members of the class
can be ordered in terms of riskiness (in the traditional sense of Rothschild and Stiglitz)
after being normalized to have zero mean. Preferences resulting from an arbitrary Bernoulli
utility function are consistent with preferences over mean and variance if and only if the
class of random variables under consideration is normalized risk comparable. It again should
be noted that the portfolio selection problem considered here (with two risky assets) need
not give rise to a class of distributions which is normalized risk comparable.4
Mathews [2002] proposes a definition of more risk averse for situations in which pref-
erences can be stated over mean and variance alone (in which case variance completely
indexes riskiness). This definition leads to an intuitive restriction on indifference curves
in (σ 2 , µ) space. Letting Si (σ 2 , µ) denote the slope of the indifference curve of agent i
at the point (σ 2 , µ), agent A is defined to be more risk averse than agent B if and only
if S A (σ 2 , µ) > S B (σ 2 , µ) for all (σ 2 , µ). The notion of more risk averse described by
Mathews corresponds to the notion of more variance averse which is discussed by Lajeri
and Nielsen [2000] and Lajeri-Chaherli [2002].
Comparing the optimal choices by two agents from any common set of risky alternatives,
Mathews shows that (when his proposed definition can be applied) an agent that is more risk
averse cannot optimally choose an alternative characterized by a higher level of risk. For
agents with quadratic Bernoulli utility functions, the notion of more risk averse proposed
by Mathews is not only applicable, but corresponds to the traditional Arrow-Pratt notion of
more risk averse.5
The outcome of the portfolio selection problem considered here and the observation by
Mathews that a more risk averse agent cannot optimally choose a higher level of risk initially
appear to be at odds with each other. However, as more light is shed upon the matter, it is
140 MATHEWS

clear that not only is there no contradiction, but further, the observation by Hadar and Seo
does not conflict with intuition.

4. Further inspection of portfolio choice

For an agent i with u i (w) = w − ki w 2 we have

Ui (α) = µα − ki µ2α − ki σα2

where µα is the expected value and σα2 is the variance of Wα . As a result,

∂Ui
= 1 − 2ki µα > 0
∂µα
and
∂Ui
= −ki < 0.
∂σα2

The first inequality follows from the assumption that 2k1 i exceeds the largest possible realiza-
tion of w; the second inequality follows from the assumption that ki > 0. Thus, an increase in
expected payoff leads to an increase in von-Neumann-Morgenstern utility, while an increase
in variance (an increase in risk) leads to a decrease in von-Neumann-Morgenstern utility.
Let µY denote the expected value of Y and µ X denote the expected value of X . Since
µ X > µY , µα = αµY + (1 − α)µ X is decreasing in α, as illustrated in figure 1. Letting
µ B ∗ denote the expected value of W B∗ and µ A∗ denote the expected value of W A∗ , α ∗B < α ∗A
implies µ B ∗ > µ A∗ .
Let σ B2 ∗ denote the variance of W B∗ and σ A2 ∗ denote the variance of W A∗ . It must be
that σ B2 ∗ > σ A2 ∗ . In order to see this, suppose that the converse is true. If σ B2 ∗ ≤ σ A2 ∗ and
µ B ∗ > µ A∗ , then any agent with a quadratic Bernoulli utility function would prefer W B∗ to
W A∗ , contradicting the optimality of α ∗A for agent A. As a result, σ B2 ∗ > σ A2 ∗ , implying that
agent A chooses a portfolio that both agents view as less risky than the portfolio that B
chooses. This outcome accords with intuition: the agent that is more risk averse chooses a
portfolio which is less risky.
Direct inspection of σα2 shows that over the entire range of α from which agents might
optimally choose, the riskiness of a portfolio decreases as α increases. Letting σY2 denote the
variance of Y , σ X2 denote the variance of X , and Cov(Y, X ) denote the covariance between
Y and X ,

σα2 = α 2 σY2 + 2α(1 − α) Cov(Y, X ) + (1 − α)2 σ X2 .

For this expression

∂σα2  
= 2 ασY2 + (1 − 2α) Cov(Y, X ) − (1 − α)σ X2
∂α  
= 2 αVar(Y − X ) + Cov(Y, X ) − σ X2 .
PORTFOLIO SELECTION WITH QUADRATIC UTILITY REVISITED 141

Figure 1. Mean and variance of portfolio.

Var(Y − X ) is always positive. Assume Cov(Y, X ) − σ X2 < 0, so that agents always wish
to diversify. As a result, for small values of α the second term dominates this expres-
∂σ 2
sion, leading to ∂αα < 0. Since σY2 > σ X2 , σα2 is as illustrated in figure 1.6 Thus, as α is
increased from zero to one, σα2 decreases up to some level ᾱ and then increases beyond
ᾱ.
Since Ui (α) is increasing in µα and decreasing in σα2 , the optimal choice of α cannot
exceed ᾱ. That is, the optimal portfolio of any such agent is characterized by α ∈ (0, ᾱ].
This can also be seen by illustrating the resulting values of (σα2 , µα ) in (σ 2 , µ) space, as
in figure 2. Different values of α lead to different portfolios along the locus from X = W0 to
Y = W1 . From the observations thus far, this locus is positively sloped at points induced by
α ∈ [0, ᾱ) and negatively sloped at points induced by α ∈ (ᾱ, 1]. Further, as α is increased
from zero to ᾱ (that is, as we move along the locus from X = W0 to Wᾱ ), the slope of the
locus increases. Clearly the optimal portfolio of any agent must lie on this locus somewhere
between X = W0 and Wᾱ , corresponding to α ∈ (0, ᾱ).
When preferences can be stated over mean and variance alone, the shape of indifference
curves has been characterized: by Meyer and by Lajeri and Nielsen (when all risks under
consideration belong to a common two-parameter family) and by Lajeri-Chaherli (when
142 MATHEWS

Figure 2. Optimal choice of agent A and agent B.

such preferences do not necessarily arise from an expected utility framework). From each
of these studies, it follows that at any point in (σ 2 , µ) space, Si (σ 2 , µ) is greater for agents
that are more risk averse in the traditional Arrow-Pratt sense.7 It is however important to
recognize that the portfolio selection problem considered here does not necessarily give rise
to a class of random variables belonging to a two-parameter family. Thus, when analyzing
such a choice for an expected utility maximizing agent, the aforementioned references do
not provide an immediate characterization of the shape of indifference curves in (σ 2 , µ)
space.
For an agent with u i (w) = w − ki w 2 , the slope of an indifference curve in (σ 2 , µ) space
is Si (σ 2 , µ) = 1−2k
ki
iµ
> 0. Considering two agents A and B such that k A > k B , at any
point in (σ , µ) space the indifference curve of A is steeper than the indifference curve of
2

B. These insights follow directly from observations made by Baron.

From here it immediately follows that 0 < α ∗B < α ∗A < ᾱ. The optimal choice of each
agent is illustrated in (σ 2 , µ) space in figure 2.
Since σα2 decreases as α is increased over the range of α from which agents will choose,
optimal portfolios characterized by larger portions of the riskier asset are in fact less risky
portfolios. Thus, we arrive at the intuitive result that a more risk averse agent chooses a
portfolio which all agents view as less risky.

5. Conclusion

One of the examples presented by Hadar and Seo when examining the implications of
Ross’ definition of more risk averse was a simple portfolio selection problem in which an
PORTFOLIO SELECTION WITH QUADRATIC UTILITY REVISITED 143

agent must decide upon the proportion of a fixed amount of wealth to invest in two risky
assets. Comparing the optimal choice by agents with quadratic Bernoulli utility functions,
they arrive at the seemingly counterintuitive conclusion that the more risk averse agent will
choose to invest more in the riskier asset. It has been argued here that this outcome does not
conflict with intuition, by pointing out that the portfolio chosen by the agent that is more
risk averse is viewed as a less risky portfolio by both agents.

Acknowledgment

I would like to thank Tom Lee, Qihong Liu, and Soiliou Namoro for helpful comments.

Notes

1. Ross states that an asset Y offering a higher return than an asset X is riskier if E(Y − X | x) ≥ 0 for all x ∈ X .
2. Lajeri-Chaherli [2002] considers a portfolio selection problem with one riskless and one risky asset (in which
there are no constraints on borrowing or short sales) in a mean-variance framework, and arrives at the intuitive
conclusion that a more risk averse agent will hold fewer shares of the risky asset.
3. As noted by Meyer, a portfolio selection problem of this nature over one riskless and one risky asset would
lead to a class of random variables satisfying his location and scale condition.
4. Thus, in order to legitimately analyze any such portfolio selection problem in an expected utility framework as a
choice over mean and variance, attention must be restricted to agents with quadratic Bernoulli utility functions.
5. When agents have non-quadratic Bernoulli utility functions the notion of more risk averse defined by Mathews
need not apply, even when preferences are over mean and variance alone. Mathews provides an example of
a class of random variables which is normalized risk comparable for which agents with differing degrees of
constant absolute risk aversion are not ordered by the proposed definition. An implication of this observation
is that for such a class of random variables, there exist points in (σ 2 , µ) space for which an agent with a higher
degree of constant absolute risk aversion has a “flatter” indifference curve.
6. If Cov(Y, X ) − σ X2 ≥ 0 (so that it never pays to diversify), then σα2 would not be as illustrated in figure 1, but
would rather be increasing in α for all α ∈ [0, 1].
7. A characterization of the shape of indifference curves in (σ 2 , µ) space is also provided by Mathews (when
preferences arise from an expected utility framework) in which, as previously noted, one agent is defined as
being more risk averse than another precisely when Si (σ 2 , µ) is greater at every point in (σ 2 , µ) space.

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144 MATHEWS

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