Book contents
- Frontmatter
- Dedication
- Contents
- List of figures
- List of tables
- Acknowledgements
- Part I Our approach in its context
- Part II Dealing with extreme events
- Part III Diversification and subjective views
- Part IV How we deal with exceptional events
- Part V Building Bayesian nets in practice
- Part VI Dealing with normal-times returns
- Part VII Working with the full distribution
- Part VIII A framework for choice
- 22 Applying expected utility
- 23 Utility theory: problems and remedies
- Part IX Numerical implementation
- Part X Analysis of portfolio allocation
- Appendix I The links with the Black–Litterman approach
- References
- Index
23 - Utility theory: problems and remedies
from Part VIII - A framework for choice
Published online by Cambridge University Press: 18 December 2013
- Frontmatter
- Dedication
- Contents
- List of figures
- List of tables
- Acknowledgements
- Part I Our approach in its context
- Part II Dealing with extreme events
- Part III Diversification and subjective views
- Part IV How we deal with exceptional events
- Part V Building Bayesian nets in practice
- Part VI Dealing with normal-times returns
- Part VII Working with the full distribution
- Part VIII A framework for choice
- 22 Applying expected utility
- 23 Utility theory: problems and remedies
- Part IX Numerical implementation
- Part X Analysis of portfolio allocation
- Appendix I The links with the Black–Litterman approach
- References
- Index
Summary
The purpose of this chapter
The taxonomy presented in the previous chapter, and our vague nods to reduced-form utility functions, provide scant guidance for the practical choice and calibration of a utility function. We find that, in order to provide practical solutions, the best way is to understand where the ‘real’ problems are, and how these can be tackled. Somewhat paradoxically, this pragmatic interest naturally pushes us in this chapter towards a deeper analysis of the theoretical problems and limitations of ‘standard’ utility theory, and of the remedies that have been proposed to fix it. This detour into some foundational aspects of utility theory should be seen as a form of reculer pour mieux avancer.
‘Inside- and outside-the-theory’ objections
The literature on the paradoxical results that ‘traditional’ expected-utility theory can produce is vast and we do not intend to deal with this body of work in a systematic manner.
Some of these objections have been raised from ‘within the theoretical fold’, in the sense that they have prompted attempts to improve and fix the theory, rather than reject it. Other lines of criticism have called for the outright abandonment of the concept of utility theory (famously, if unkindly, referred to by Rabin and Thaler (2001) as Monty Python's ‘dead parrot’). We discuss briefly those critiques that have a direct bearing on our study.
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- Portfolio Management under StressA Bayesian-Net Approach to Coherent Asset Allocation, pp. 353 - 370Publisher: Cambridge University PressPrint publication year: 2014