Question

Suppose that we interview a group of investors who chose to invest 60% of their portfolio in large US stocks and 40% in the risk-free asset. We then ask them which asset from (2) that they prefer. Most answer that they prefer (b)(an asset with E(r) = 10% and ? = 20%) over (a)( an asset which has E(r) = 5% and ? = 0) . If we believe that the investors in the group are consistent in their choices, what does this imply about the quadratic utility function? If we believe that the quadratic utility function is the correct utility function, what does this imply about the consistency of investors’ preferences?

Answer 1

see quadratic utility function helps us to know about the investor's behavior, but at the same time behaviours are not always suttle or i may say rigid, in this "E(r)" can be called as unsytematic return because we know where it came from but "?" can be called as systematic return which we dont know where it came from. so even there's a risk in b because 20% is coming from unknown factor which we wont event know would let it happen again or not and "A" not having any this kind of risk but they will still go with "B" because it gives you more "E(r)" than "A" and a rational investor always wants to gain more!

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