A Novel Approach to Construct Portfolio that Addresses Variance of Utility Function

Abstract

Many studies in the area of portfolio selection have done based on trade-off among various moments especially between mean and risk of sample returns. Merton (1980) argued that the instability of portfolio weights and sampling errors are due more to estimate the amount of mean. Indeed, it is difficult to estimate the expected return from time series of realized expected return. By this paper, we first answer to this question how to eliminate the wrong effect of mean sample returns instead of ignoring it from calculating portfolio weights and how would be the relation of other moments after this consideration. Second, the substantial evidence from experiments shows that hide information exposes ambiguity aversion to investor’s behavior, and hence decision making under ambiguity for portfolio choice has led to improving tractability of the main features of asset returns. By considering the volatility of utility preferences as ambiguity then individuals prefer to stabilize their utility preferences to maximize their expected utility.

Keywords: utility function, portfolio selection, risk aversion, ambiguity aversion