Expected Utility Theory
Let us now turn to what, in the eyes of the investor, is probably the main raison d’être of investment, namely, profitability. In focusing on risk in our first chapter, by no means do we belittle this all-important function of investment. Our discussion of risk simply serves to emphasize that, in arriving at an investment decision, the risk of the investment has to be weighed against its profitability. Thus, both profitability and risk have to be incorporated in the decision making process. We devote this chapter to the expected utility criterion that takes into account the whole distribution of returns (risk and return).
KeywordsUtility Function Cash Flow Stochastic Dominance Expect Utility Theory Certainty Equivalent
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- 4.See F.P. Ramsey, “Truth and Probability,” in The Foundations of Mathematics and Other Logical Essays, London: K. Paul, Trench, Trusner and Co., 1931.Google Scholar
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