Mean-variance and expected utility: the Borch paradox

DOI10.1214/12-STS408MaRDI QIDQ252755zbMATH OpenFDO

Authors David Johnstone, Dennis Lindley

Publication date 4 March 2016

Published in Statistical Science (Search for Journal in Brave)

Full work available at URL https://arxiv.org/abs/1306.2728, https://projecteuclid.org/euclid.ss/1369147913

zbMATH Keywords

Borch's paradoxCAPMexpected utilitymean-varianceportfolio theoryprobability mixture

Mathematics Subject Classification ID

Applications of statistics to actuarial sciences and financial mathematics (62P05) Decision theory (91B06) Utility theory (91B16) Portfolio theory (91G10) Statistical methods; risk measures (91G70)

Abstract: The model of rational decision-making in most of economics and statistics is expected utility theory (EU) axiomatised by von Neumann and Morgenstern, Savage and others. This is less the case, however, in financial economics and mathematical finance, where investment decisions are commonly based on the methods of mean-variance (MV) introduced in the 1950s by Markowitz. Under the MV framework, each available investment opportunity ("asset") or portfolio is represented in just two dimensions by the ex ante mean and standard deviation $(mu,sigma)$ of the financial return anticipated from that investment. Utility adherents consider that in general MV methods are logically incoherent. Most famously, Norwegian insurance theorist Borch presented a proof suggesting that two-dimensional MV indifference curves cannot represent the preferences of a rational investor (he claimed that MV indifference curves "do not exist"). This is known as Borch's paradox and gave rise to an important but generally little-known philosophical literature relating MV to EU. We examine the main early contributions to this literature, focussing on Borch's logic and the arguments by which it has been set aside.

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Cited in

(6)

• Variance aversion implies \(\mu-\sigma^ 2\)-criterion
• Auctioning risk: the all-pay auction under mean-variance preferences
• Portfolio optimization by a bivariate functional of the mean and variance
• Elementary proof that mean-variance implies quadratic utility
• Jensen-Marshall-Ky Fan-type inequalities and their applications in business profit management model
• When Harry met Kelly: an overlooked result in the classical theory of optimal capital growth

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