Investor’s Utility Analysis


Investor’s Utility Analysis


Utility is the satisfaction the investor enjoys from the portfolio return. The investor gets mire satisfaction or more utility in X+1 rupees than from X rupees. The utility function makes certain assumption about an investors’ taste for risk. The investors are categorized into three category:










The curve ABC are three different slopes of utility curves. The upward sloping curve A shows increasing marginal utility. The straight line B shows constant utility, and curve C shows diminishing marginal utility. The constant utility, a linear function means doubling of returns would double the utility and it indicates risk neutral situation. The increasing marginal utility suggests that the utility increases more than proportion to increase in return and shows the risk. The curve C shows risk averse investor. Investors generally, like to get more returns for additional risks assumed and lines would be positively sloped. The risk lover’s utility curves are negatively sloped and coverage towards the origin. For the risk fearing, lower the risk of the portfolio, happier he would be. The degree of the slopes of indifference curve indicates the degree of risk aversion.  The conservative investor needs larger return to undertake small increase in risk. The aggressive investor would be willing to undertake greater risk for smaller return.



Indifference map and the efficient frontier


Each investor has a series of indifferent curves. The utility of the investor or portfolio manager increases when he moves up the indifference map from I1 to I4. He can achieve higher expected return without an increase in risk. I2 touches the efficient frontier at point R. even though the points T and S are in the I2 curve, R is the only attainable portfolio which maximizes the utility of the investor. Thus, the point at which the efficient frontier tangentially touches the highest indifference curve determines the most attractive portfolio for the investor.

 Assumptions:
1.      Risk: variability in return is risk. In this theory main focus is on correlation coefficient. Under this model invest decision is based on expected return and variance of return.

2.      For a given level of risk investor prefer higher return to lower return or for a given level of return investor prefer lower risk than the highest risk
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