Charactering Investors

And Capital Allocation

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W. Suo

Objective
How to describe an investor?

Risk aversion and utility function

Capital Allocation

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Risk free asset and risky portfolio

W. Suo

Investors Life Cycle

Accumulation Phase
Early to middle years
Low net worth
Long time horizon
Bearing risk for higher returns is reasonable
Consolidation Phase
Mid-point and later
Earnings exceed needs
Moderate risk to protect investments
Spending Phase
Earnings have mostly ceased
Time horizon is shorter
Protection of assets important
Inflation an immediate concern

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W. Suo

How to Characterize an Investor?

Economic theory assumes every person seeks to
maximize their happiness or utility

The more wealth a person has, the more utility they have
The higher an investments return, the greater a persons
wealth, therefore, the greater their utility

However, uncertainty about expected returns makes

the decision more complex
We

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must maximize our expected utility

W. Suo

Types of Investors
Risk-averse investors

They require higher returns to encourage them to accept greater risks

At higher levels of risk, investors are less willing to accept risk unless they
receive increasingly larger risk premiums

Risk-loving investors

Prefer to enter risky gambles even given the high likelihood of diminishing
wealth

A theoretical possibility but not a reality with rational investors

Risk-indifferent investors

Prefer higher returns, but greater risk doesnt affect their happiness

In investments, we always assume people are risk averse

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W. Suo

How to describe an investor?

Various factors determine an investors risk-return
preferences

Agethe elderly are usually more risk averse

Economypeople are usually more risk averse during a recession
Pessimists are usually more risk averse than optimists
Traumatic evens tend to make people more risk averse
etc

Risk Tolerance = Willingness + Ability

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W. Suo

Dominance Principle For Risk averse Investors

Expected Return

4
2

3
1

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Variance or Standard Deviation

2 dominates 1; has a higher return

2 dominates 3; has a lower risk
4 dominates 3; has a higher return
What about 1 and 3, or 2 and 4, or 1 and 4?
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Risk Aversion & Utility

Utility Function

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represents an investment opportunity

The constant measures the degree of risk aversion

W. Suo

Example:

Risky Investment

100

Risk Free T-bills

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Profit = 50

Profit = -20
Profit = 5

Expected return = 22%, STD = 34.29%

Risk Premium = 22-5 = 17

Is the premium high enough?

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Risk Aversion and Value:

The Sample Investment

= 22% - .5 (34%) 2
Risk Aversion
Utility
High
5 -6.90
3 4.66
Low
1 16.22

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T-bill = 5%

W. Suo

Utility and Indifference Curves

Represent an investors willingness to trade-off return and risk
Example (for an investor with A=4):

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Exp Return (%)

St Deviation (%)

10
15
20
25

20.0
25.5
30.0
33.9

2
2
2
2
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Indifference Curves
Expected Return

Increasing Utility
Standard Deviation
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Indifference Curves in -E(r) Space

Indifference curves represent points at which a person is equally
happy (indifferent)

In all cases,

Investor
is highly
risk
averse.

Investor
is a risk
lover.

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Investor is
moderately
risk averse.

Investor is
indifferent
to risk.

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Capital Allocation
Allocating capital between risky assets and risk free assets
Possible to split investment funds between safe and risky
assets

Risk free asset: proxy; T-bills

Perfectly price-indexed bond the only risk free asset in real terms;
T-bills are commonly viewed as the risk-free asset;
Money market funds - the most accessible risk-free asset for most investors.

Risky asset: stock (or a portfolio)

Can represent the total investments in risky assets

Examine risk/return tradeoff

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Demonstrate how different degrees of risk aversion will affect

allocations between risky and risk free assets

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Portfolios of One Risky Asset

and One Risk-Free Asset

Assume a risky portfolio P defined by :

E(rp) = 15% and
The available risk-free asset has:
rf = 7% and
The proportions invested:
y% in P and (1-y)% in rf
Expected returns & standard deviation for combinations

= complete or combined portfolio

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W. Suo

Combinations Without
Leverage

If ,

If

or

If

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or

or
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Possible Combinations

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16.5%

W. Suo

CAL (Capital Allocation Line)

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W. Suo

Using Leverage with

Capital Allocation Line
Borrow at the Risk-Free Rate and invest in stock
Using 50% Leverage

Question: what does the CAL represent?

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W. Suo

Optimal Allocation
Given an investors risk aversion, how to determine
the optimal allocation?

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W. Suo

CAL with Risk Preferences

E(r)

7%

Borrower

Lender

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W. Suo

Risk Aversion and Allocation

Greater levels of risk aversion lead to larger
proportions of the risk free rate
Lower levels of risk aversion lead to larger
proportions of the portfolio of risky assets
Willingness to accept high levels of risk for high
levels of returns would result in leveraged
combinations

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W. Suo

Mathematically
The optimal investment in is

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W. Suo

CAL with Higher

Borrowing Rate

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W. Suo