RELATIVE RISK AVERSION AND PORTFOLIO CHOICE

Pablo A. Munoz and Esteban I. Flores

Abstract
The aim of this paper is to show the expected utility theory over time and its evolution onto what is
now known as the risk aversion theory. This paper also highlights the importance of the link between
the relative risk aversion and the selection of an optimum investment portfolio (Relative Risk Aversion v/s
Portfolio Choice).
This document also encompasses the basic axioms or maxims applicable to the utility functions developed
in microeconomics. It also includes topics such as making a choice under conditions of uncertainty and
analysis of the existing expected utility models checking their consistency.
Furthermore, in the same context, it carried out an analysis of the risk aversion theory developed by
Pratt and Arrow by using the relative risk aversion as the main was of measuring risk. The consistency of
the main existing models quoted in the current textbooks and related literature which links the risk tolerance
with the portfolio choice is put to the test through a sample transacted at Santiago stock exchange.
The paper goes on to suggest, on the basis of the theoretical development described in it, a new approach
aimed at the identification of optimum portfolios by means of the relative risk aversion approach.

Key words: Risk Aversion, Expected Utility Theory, Portfolio Choice.

JEL Classification: C81, D81, G11.

Pablo A. Munoz Ceballos is Economist and President of Consulting Forex Chile S.A., http://www.consultingforex.cl, e-

mail: pmunoz@consultingforex.cl
Esteban Flores,Ph.D.,Departamento de Actuara y Seguros, Instituto Tecnologico Autonomo de Mexico (ITAM), e-mail: este-

ban.flores@itam.mx

1
1 Introduction
The observation and analysis of the attitude shown by people when confronted with periods or conditions of
uncertainty dates back centuries. Since Bernoullis time, human behaviour has been observed, specially when
this behaviour is conected with making a decision under risky conditions. This is done in order to explain some
events such as why a person takes out an insurance. What makes some people not to invest in assets which can
be very profitable? The point here is to know peoples tolerance when confronted with a financial risk and what
we can do with this information [12].
The study and analysis of risk aversion has been fruitful. In the sixties Pratt and Arrow developed a
risk aversion measurement and the main advantage of it is its quantitative status and it is, therefore, a more
powerful feature as opposed to a mere qualitative observation [9, 1], despite this, and bearing in mind the
complex algorithms required for determining a functional adjustment, its modelling for empiric applications is
coupled to a myriad of technology breakthroughs.
The developed measurement of quantitative aversion can have a number of varied applications. However,
one of the most interesting ones is the link with the Markowitz model of investment portfolio [17, 3, 11, 15].

The figure above shows an illustration of aversion measurement for the selection of the optimum portfolio
(risk-return combination) while considering the persons own risk tolerance. The more tolerant to risk the person
is, the more willing he/she is to undertake risk in exchange for a bigger return.

2
2 Expected utility theory and expected utility models
It was in the fifties that the choice theory when confronting uncertainty was considered as one of the remarkable
events in the history of economic analysis since it was a sound axiomatic foundation which was fundamental for
the risk theory [13, 21, 23, 22] special reference must be made here to Machina (1987).

2.1 Choice axioms

Some prior definitions must be made before enumerating the most important axioms [23].
Definition 2.1. The basket of goods is the consumers choice. The basket of goods belonging to <2 is to be
referred as (xi , yj ).
Definition 2.2. It is stated that an individual has a strict preference when such individual strictly favours one
basket from another, that is to say: Z1 = (x1 , y1 )  Z2 = (x2 , y2 ) which means Z1 is strictly preferred to
Z2 Z1  Z2 .
Definition 2.3. If a person has an indifferent stance vis-a-vis the choice between Z1 and Z2 then we can
state that Z1 Z2 , which is the indifference relation. Figure 1 illustrates those baskets that are mutually
indifferent.

Definition 2.4. If an individual adopts an indifferent stance between 2 baskets or prefers one of them, we can
say such person has a weak preference. Thus Z1  Z2 .

Figure 1: Indifference Points for two goods

Once these definitions are clear, the axioms for such preferences are defined.

Axiom 1. Complete. This axiom states that it is possible to compare 2 given baskets Z1 and Z2 and thus we
can say: Z1  Z2 o Z2  Z1 or both at the same time which means Z1 Z2 .
Axiom 2. Reflective. The reflective axiom assumes that every basket is as good as it can be by itself, thus
meaning Z1  Z1 .

Axiom 3. Transitivity. If an individual corresponds to Z1  Z2 while being equivalent to Z2  Z3 Z1  Z3

at the same time.
Given the set of axioms above, we can build the profit functions [22, 13]. However, before doing so, we must
define the following

Definition 2.5. The set of goods baskets which are indifferent with each other is referred to as Indifference
Curve. Figure 2 is an illustration of an indifference curve.
It can be assumed that that the utility functions are level sets of indifference curves. This is,

U = f (Z) . (1)

3
 Figure 2: Indifference Curve for two goods, U0

For example, if we have Z1 Z2 Z3 , then

U0 = U (Z1 )
= U (Z2 )
= U (Z3 ) .

But if Zi  Zj , then U (Zi ) > U (Zj ) which means that the indifference curve of Zi is located further away
from the origin of the indifference curve Zj . On the one hand we can also state that the functional form of U
defines the shape of the indifference curves and that the indifference curves of an individual cannot intersect
each other. On the other hand must include the assumption that the individual will always prefer more than less.
This has some performance implications for U , because it means that U is increasing throughout its domain.

2.2 Choice under uncertainty

Now that the choice axioms of the microeconomics theory have been shown, we will to examine the choice under
uncertainty theory.
For the analysis of the choice under uncertainty we must add some assumptions to the axioms already
defined. This means that the preference, from now on , is asymmetric and negatively transitive, [13].
Axiom 4. Substitution. Being p and q the probability distribution so that p  q. Let us also assume that a is
located between (0, 1) and that w is another probability distribution, then we can conclude that ap + (1 a)w 
aq + (1 a)w.

The previous axiom shows that in the final probability distributions, the consumer gets (1 a)w. It is
assumed that this common part will not influence the individual preferences, then the difference occurs only
between p and q and as p  q, then ap + (1 a)w  aq + (1 a)w.
Axiom 5. Measurability. If p q and q w, then only one probability, so that an individual will be
indifferent between: q [p + (1 )w].
Axiom 6. Ranking. Let x, y, z, w be risky alternatives and and probability distributions. If x  y  z
x  w  z, we also have that y x + (1 )z w x + (1 )z then,

> yw
= yw .

2.3 Expected utility theory

Prior to developing the expected utility theory, risky events were classified according to their mathematical
probability. In other words, if we assume that X is a random variable that represents a monetary reward for

4
 Pn
entering
Pn a game and Y is another random variable with similar features, then: E[X] = i=1 xi pi > E[Y ] =
i=1 yi qi where p and q are the probability distributions of x and y respectively, then x  y (x is preferred
to y). However, the mathematician Nicolas Bernoulli figured out the process known as the Saint Petersburgs
Paradox in 1728.

Lets assume that you have the opportunity to join in a repetitive game of throwing a coin and
you win $1 for 1 head and $2 if 2 for two consecutive heads, $4 for 3 consecutive heads, $8 for 4
consecutive heads, etc. Which is the maximum amount of money you will be willing to pay to join
in the game once?.

First, let us determine the expected value of the game. We have: (1/2)$1 + (1/4)$2 + (1/8)$4 + ... = $,
then this should be the option to be preferred against any other choices. However, it is very unlikely that a
rational person is willing to pay that much for joining the game.
The answer to this paradox was proposed by Daniel Bernoulli [2], who argued that winning $100 is not valued
in the same way as winning $50 twice, This is the basic hypothesis in Von Neumann-Morgensterns development
of the utility functions [24]. Now, instead of using an expected value, the preference evaluations will be made
in terms of
Xn
U (xi )pi = E[U (x)] , (2)
i=1

which is the expected utility. Thus, rational people make decisions that lead to a maximum enhancement of
their expected utility wealth.
One of the most important aspects of the expected utility theory is that it assumes the existence of the
Cardinal Utility. Thanks to this assumption, we can make monotonous transformations to the original utility
function and get a different function in scale terms but with the same representation features [1, 6, 14, 24].
The monotonicity feature of von Neumann and Morgensterns utility functions not only allows transforma-
tions in the vertical axis u(x) without affecting the slope function u(x) but it also allows us to illustrate the
Stochastic Dominance feature, which is analogous to say that you prefer more instead of less [14].

2.4 Expected utility models

As stated before, the theory of choice when confronted with uncertainty is based on a set of axioms aimed at the
formation of preferences. From this starting point it is possible to define the utility functions as well as to set
the expected utility to include the assumption of features such as the independence or linearity in probabilities.
See Machina, (1987).
Cox and Sadiraj (2001) identified 3 types of models of expected utility. These models are used depending
on the decision context that is influencing the individual undergoing the experiment. These models are:

1. Terminal wealths expected utility models E[U (Wf )].

2. Incomes expected utility models E[U (I)].
3. Initial wealth and incomes expected utility models E[U (Wi &I)].

2.4.1 Expected utility models of terminal wealth

As the name suggests, the expected utility models of the terminal wealth are based on the results of the game
and they correspond to final wealths amounts. Let us consider 2 events with monetary gains y1 , y2 and y3 , for
which we can assume that their occurrence probabilities are p1 , p2 and p3 respectively and that the probability
distributions are simple. See Kreps, (1994). This means that p1 + p2 + p3 = 1. Also, assuming w as the original
wealth, the model is equivalent to
3
X
E[U (Wf )] = pi u(w + yi ) . (3)
i=1

According to Rabin (2000), these model types show inconsistency problems for small-scale bets as opposed to
sizable ones [19].

5
2.4.2 Income expected utility models
These models are based on the idea that the prize amounts are income. This implies changes in wealth which
are registered as profits or losses. Using the previous notation, the shape of this kind of models is equivalent to
3
X
E[U (I)] = pi u(yi ) . (4)
i=1

This model does not have the problems mentioned by Rabin. A demonstration of this is shown at [7].

2.4.3 Initial wealth and income expected utility models

This kind of model is proposed by Cox and Sadiraj, (2001). It assumes that the prizes are lined up pairs of
initial wealth w and income yi . Then, using the same notation shown above, the expected profit function would
be modeled by
X3
E[U (Wi &I)] = pi u(w, yi ) . (5)
i=1

Like the expected utility models, these type of models do not fit in Rabins inconsistency criticism.

6
3 Risk aversion
Since the XVII century it has been argued that people show attitudes of risk aversion. Such aversion accounts
for the existence of certain behavioral inclinations like taking a life insurance policy. Before going any further
we must attempt a definition of the word risk.
Definition 3.1. We can define risk as the possibility of any unwelcome event ever taking place.
Nowadays, risk evaluation has become a crucial activity whose importance cannot be overemphasized.
There are professionals whose job is to evaluate the possibility that non-desirable events may take place and
also to minimize their potential impact.
Arrow (1965) and Pratt (1964) developed an aversion measurement based on Von Neumann and Mor-
gensterns expected utility theory. The advantage of this unit of measurement is that it is a quantitative
measurement as opposed to a qualitative judgement [1].

3.1 Risk aversion and concavity

As it will be described in the following pages of this paper, Pratt-Arrows measure is merely a measure of the
curvatures degree in the wealth utility function U (w). This means that the higher the concavity function is,
the higher the degree of risk aversion the person has. We only need to define this to assume that if the function
is a convex type, then the behavior of the same individual will show his/her inclination towards risky situations.
This is due to the fact that risk eventually turns into a profit or a reward. Figure 3 shows the 3 types of risk
attitudes that can come from the utility functions U (w).

Figure 3: Functions which reflect the attitude towards risk

We can define 3 types of attitudes towards financial risk. These are

1. The risk lover U (w) is convex.

2. Indifferent towards risk U (w) is linear.

3. The risk averse U (w) is concave.

3.2 Absolute risk aversion (ARA) and relative risk aversion (RRA)
In this section we will define Pratt-Arrows measure of risk aversion [1, 18]. To start with, we will define its
components
w = W ealth
U (w) = U tility of wealth
We must also assume that U (w) is twice differentiable

U 0 (w) = W ealth marginal utility

U 00 (w) = Exchange rate of the wealth marginal utility

U 0 (w) > 0 . (6)

7
The expression (6), ensures a growing profit function throughout its domain and, therefore, the individual will
always prefer more to less.
Furthermore,

lim U (w) , (7)

w0
lim U (w) , (8)
w

they exist and they are finite.

If limw U (w) = a then the utility for the individual will have a boundary a.
Now, let us consider that an individual, whose wealth is w0 , has the possibility of entering a game where his
chances of winning and losing are even (represented by g), this means he/she has either a probability of getting
w0 with probability 1 or being part of the game where he/she is likely to get

w0 g with probability p = 0.5

or
w0 + g with probability p = 0.5 .

Since the game is actuarially-neutral, any individual who, by definition is averse to risk, will always opt for
not entering the game. On the contrary, a risk lover will prefer the expected profit value that the game could
provide thus he will join in. For the person who is risk indifferent, it is obvious to assume that he/she will not
care whether he/she is admitted into the game or not.
Formally, a risk averse is characterized by

U (w0 ) > 0.5U (w0 g) + 0.5U (w0 + g) (9)

rewriting
U (w0 ) U (w0 g) > U (w0 + g) U (w0 ) , (10)
the utility of the safe wealth is always higher than the utility from a neutral-probability game.
This has implications in the behaviour of U 0 (w) for it makes the U exchange rate take a decreasing trend.
This means that
U 00 (w) < 0 . (11)

Figure 4: Utility Function for a Risk Averse

Figure 4 shows a game, represented by the straight line [a, b]. Please note, that the function utility level is
always higher than the profit level of the game itself. This means

U (w) > G(a, b : ) , (12)

where

G(a, b : ) = U (a) + (1 )U (b) .

From the same graphic it can be concluded that

8
 1. If U [E(w)] > E[U (w)] The individual is risk averse.
2. If U [E(w)] < E[U (w)] The individual is risk lover.
3. If U [E(w)] = E[U (w)] The individual is indifferent to risk.

Definition 3.2. The wealth value evaluated on U and which fulfils the U () = G(a, b : ) = U (a) + (1
)U (b) condition will be called equivalent secured wealth and it is known as certainty equivalent.
From the viewpoint of the concavity of the profit function, it would be enough to verify that the expression
[11] is fulfilled and one would be prove to use U 00 (w) as a risk aversion measure. However, because of what
it has already been stated, this has serious formal inconveniences mainly due to the fact that profit functions
represent the order of preferences. Von Neumann-Morgensterns utility functions, in particular, are cardinal
utility functions [14], and as such they are susceptible to linear transformations of the aU (w) for a > 0. Thus,
whenever you multiply U (w) by the constant a, we will be also multiplying U 0 (w) and U 00 (w) by the same
constant. In this way U 00 (w) numeric value loses significance when it comes to classify the aversion grade. An
intelligent amendment of the former that brings a solution to the inconvenience and at the same time does not
alter the properties of the profit function is

U 00 (w)
RA (w) = . (13)
U 0 (w)
This expression is called Absolute Risk Aversion, ARA.
Also, the elasticity of the wealth marginal utility can be defined as
U 00 (w)
RR (w) = w . (14)
U 0 (w)
This is known as Relative Risk Aversion. A property of this measure is that it remains unaltered no matter
what changes are made in the unit values of U (w) and w.
We know that U 0 (w) is > 0, because we have said that U (w) is strictly an increasing factor. Also, we said
that for an averse individual, U 00 (w) is less than 0, meaning that U (w) is concave, i.e., U 00 (w) is strictly a
decreasing factor.
The bigger the value of RA is, the more averse to risk the agent becomes. Let us see the case of an individual
that has the linear utility function U (w) such as

U (w) = aw + b .

We have
U 0 (w) = a
and
U 00 (w) = 0
then
RA = 0 .
As we have stated before for this type of utility functions, all the above implies that the agent is indifferent to
risk.
Now let us assume that the individuals utility function can be expressed as follows

U (w) = w ,

where the wealth marginal utility for this function is

U 0 (w) = w1

and because of this, the exchange rate of the wealth marginal utility will be

U 00 (w) = ( 1)w2 ,

based on the previous expression we can calculate the absolute risk aversion (ARA) as

U 00 (w) ( 1)w2 1
ARA = 0
= = .
U (w) w1 w

9
It is clear that ARA is a decreasing function and the aversion grade is very much dependant of the parameter
of the potential function that represents the individuals profit or earnings. Please, note that for this function
to be concave, the parameter value must be between 0 < < 1.
ARAs implementation poses an inconvenient in the application when it comes to classifying the individuals.
This is due to the units used for representing the wealth. Thus, a better measure of a risk classification is the
relative risk aversion (RRA) which, in other words, is the elasticity of the wealths marginal profit. For the
previous model, RRA is defined by
1
RRA = wARA = w =1 .
w
Proposition 3.1. If U 0 (w) > 0 w, that is U (w) is increasing throughout its domain, and if U 00 (w) 0 w,
it means that U (w) is strictly concave, thus

U 00 (w)
0 RRA = w <1 . (15)
U 0 (w)

Let us take the following expression

U (w) = w .
The scale parameter moves the function along the ordinate axis and determines its curvature degree, so we
will obviously assume that 0 < 1 because this is the condition that fulfils the axioms of the utility theory.
Now, if we calculate RRA, the result will be: RRA = 1 which is consistent with proposition 3.1.

10
4 Portfolio choice
It is assumed that for a rational investor, the expected return on portfolio, E(Xp ) is an asset and that the
portfolio variance Var(Xp ) = p2 is a drawback.
Let us also assume that an investor plans Pn to invest an X amount of money in a portfolio of stock shares.
The vector w = (w1 , w2 , . . . , wn )T , where j=1 wj = 1, represents the relative amount invest in the asset j, for
j = 1, . . . , n.
Thus, the portfolio return would be
Xn
Xp = wj Xj .
j=1

The expected return of the portfolio is given by

n
X n
X
p = E(Xp ) = wj E(Xj ) = wj j . (16)
j=1 j=1

The variance of return of the portfolio is defined by

n X
X n
Var(Xp ) = p2 = wi wj Cov(Xi , Xj )
i=1 j=1
n X
X n
= wi wj ij . (17)
i=1 j=1

We will now define = (1 , 2 , . . . , n )T , where i = E(Xi ), and furthermore

P
= Cov(Xi , Xj ). This is the
return covariance matrix. Then, starting from (16) and (17), we can get

p = E(Xp ) = wT

and
X
Var(Xp ) = p2 = wT w .

The idea is to obtain the highest possible return with a minimum risk. This aim calls for the configuration of
efficient assets and, because of this, we will issue the following definition [17]:
Definition 4.1. A portfolio X will be efficient if only there is no Y portfolio, and is done in such a way that:
2
Y X and Y2 X .

11
5 Results
5.1 Development of the questions
The development of questions is closely linked to each individuals construction of the profit function. In other
words, each question is structured in such a way that the individuals answer could secure a point in the point
cloud of its utility function. The methodology for the preparation of the questions is proposed by Machina and
it was used in other recent studies [4].
Machina proposes the profiling of the point cloud of the utility function by means of a structuring of successive
games, where the extreme values are allocated a random utility value and the individual is questioned in such
a way that his/her answer has another value in the utility function. It is here where the definition [3.2] will be
useful to us. The questions were structured as follows:
With U (0) = 0 and U (M ) = 100, where 0 and M were the extreme values for the total number of questions,
then the profit was defined in line with each question.
1. U () = 0.5U (0) + 0.5U (M ) = 50
2. U () = 0.5U () + 0.5U (M ) = 25 + 50 = 75
3. U () = 0.5U () + 0.5U (M ) = 37, 5 + 50 = 87, 5
4. U () = 0.5U (0) + 0.5U () = 25
5. U ( ) = 0.5U (0) + 0.5U () = 12, 5
6. U () = 0.5U (0) + 0.5U ( ) = 6, 25
7. U () = 0.5U () + 0.5U ( ) = 43, 75
8. U () = 0.5U () + 0.5U (M ) = 93, 75
9. U () = 0.5U () + 0.5U () = 62, 5
10. U () = 0.5U ( ) + 0.5U () = 37, 5
11. U () = 0.25U () + 0.5U () + 0.25U () = 54, 68
12. U () = 0.25U () + 0.5U () + 0.25U (M ) = 84, 37
13. U () = 0.5U () + 0.5U (M ) = 96, 87.
With the utility values obtained and mixed with their own answers, it was possible to obtain the point cloud
which was later adjusted.
The wealth value (income) was standardized in such a way that whenever a specific w value needs to be
evaluated, the results are comparable and the specific value of w is 200.

5.2 List of models to be adjusted

As stated previously, we are interested in functional forms with defined characteristics. Our interest is for
particular concave functions, because it is these functions which represent the persons that are averse to taking
risks. Their attitude is in line with a rational investment behaviour. Furthermore, the models are single-
variation types, which means they have only one explicative variable. Although the term single-variation type
is not strictly correct because there are 2 variables in the model U (w) and w, we will continue to refer to them
as single-variation types, simply because they only have one explicative variable.
In order to choose the models that will be adjusted, we first took into account the theory for which the model
is perfectly specified, and later we considered the statistics properties of each of them. Some models were taken
from Ratkowsky [20]. The list of adjusted models is as follows:

5.2.1 Model with only one parameter

U (w) = w , <1 , (18)

where
1
ARA = ; RRA = 1 .
w

12
5.2.2 Models with two parameters

w
U (w) = , (19)
+w
where
2 2
ARA = ; RRA =
.
+w w +1

U (w) = w , 0<<1 , (20)

where
U 0 (w) = w1 ; U 00 (w) = w2 ( 1) .
Then,
1
ARA = ; RRA = (1 ) .
w

w
U (w) = , , > 0 , (21)
1 + w
where,
2 2
ARA = ; RRA = 2 .
w + 1 w + 1

U (w) = (1 + w) , 0<<1 , (22)

where  
1 1
ARA = ; RRA = w 1 .
w+1 w+1

5.3 Software modeling

The modeling through software entailed the following phases

1. Inclusion in the Non linear Estimation tool of each model to be fitted.

2. Regression of each model.
3. Analysis of the residuals for each fitting.
4. Definition of the discriminating and selecting criteria of each model.
5. Presentation of the best fitted model.
6. Compilation of a summary with the values for the parameters of the selected model.

5.4 Determining the individual profile

With the adjusted data it was possible to know the shape of the profit function for each individual. The next
step was to determine their degree of risk aversion. To do this, we took the risk aversion functions of each
individual and produced his profile.
The risk classifying measure was the Relative Risk Aversion (RRA), where a higher RRA rating had a
consequent higher degree of risk aversion. Furthermore, we allocated its value as RRA 0.
It was only possible to collect data through the computer, particularly via e-mail. This was due to the
fact that every question depended on the previous answers. The questionnaire included 13 questions developed
according to theory.
After the data collection, each case was processed with a computer programme included in the Statistica
v6.0. Package. This programme was produced in relation to the needs of the problem being studied. While the

13
 Model Times Best Fit % RRA Avrg.
1 0 0,00% 0,00
2 1 5,26% 0,87
3 10 52,63% 0,28
4 0 0,00% 0,00
5 8 42,11% 0,31
Total 19 100,00% 0,33

Table 1: Summary of the adjusted models

data was being processed, the macro automatically processed all the models and delivered the necessary results
for the selection of the best adjusted model. The purpose of this was to represent the profit function and,
therefore, to be able to determine the individual profile.
Our general impression is that the selected models got a good fitting. To select the best model it is not
enough to observe the determination coefficient. First, it must fulfil the basic adjustments for residuals and
these must be distributed to conform with N (0, 2 ) and Cov(i , j ) = 0. [8, 10, 5, 16].

14
6 Relative risk aversion and portfolio choice
The available literature mainly focuses on 2 viewpoints linking the risk aversion theory with the portfolio
selection.
Panjer et al. (1998) suggests the formulation of the following optimization problem:

max{2 p p2 }
n
X
s.a xi = 1 ,
i=1

1
where represents the risk tolerance and it is an approximation of RRA
However, the maximizing results of the tests undertaken with adjusted models show that they were incon-
sistent with the cases showing low aversion levels, that is when the RRA is close to 0. This can be attributed
to the approximation of the objective function shown by Panjer [17].
Another way is the one supported by Bodie, Kane & Marcus, (1999). They suggested another way of
modeling the problem through a maximum-enhancement approach:

U = E(Rp ) 0.005Ap2 , (23)

where A is a risk aversion index, being 0.005 its convention value and A is determined by heuristic judgements.
Whenever the value for A increases, the degree of risk aversion is also intensified.
This modeling has a very logical pattern, but it shows shortcomings when it comes to determining the value
for A. The question that comes is: How can we link the portfolio theory with the results obtained? We know
that the RRA values are to be found between 0 and 1, being RRA = 0 the typical attitude of a risk indifferent
individual whereas with RRA = 1 we have the attitude of a person who is extremely averse to risk.

6.1 Proposal
When applying the RRA to the mean-variance model, we propose a variation of Bodies model by building the
following relationship:  
RRA 2
max U = E[Rp ] . (24)
1 RRA p
Please note that if RRA 0 the profit maximization will be given only by the E[Rp ]. This attitude is consistent
with a risk indifferent person. Now if RRA 1, then we will be allocating a great weight to risk and we will
demand high values to E[Rp ] in order to offset the risk taken.
Although this function is consistent with the axioms specified in the previous sections of this paper, we can
not forget that the RRA values fluctuate between [0; 1) [see proposition 3.1].
To see whether the relation (24) works, we selected 23 shares which currently enjoy the highest prominence
in the Santiago Stock Exchange and got their quoted values for the period ranging from 2 January 1998 to 2
July 2004. The values were extracted from the Economatica database.
c Thereafter we obtained the monthly
returns of each share and their respective variability. Furthermore, we proved that the return distribution is
close to normal. We also got the return correlation and covariant matrix.
With this data and Microsofts Excel optimization Solver tool, each and every case was processed. Thus, we
managed to determine the optimum portfolio configuration for each individual depending on his or her individual
risk aversion index. The results achieved were rated as satisfactory and consistent.

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