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Bridge over ocean
1 September 2004 Financial Analysts Journal Volume 60, Issue 5

Asset Allocation without Unobservable Parameters

  1. Michael Stutzer

Some asset allocation advice for long-term investors is based on maximization of expected utility. Most commonly used investor utilities require measurement of a risk-aversion parameter appropriate to the particular investor. But accurate assessment of this parameter is problematic at best. Maximization of expected utility is thus not only conceptually difficult for clients to understand but also difficult to implement. Other asset allocation advice is based on minimizing the probability of falling short of a particular investor's long-term return target or of an investable benchmark. This approach is easier to explain and implement, but it has been criticized by advocates of expected utility. These seemingly disparate criteria can be reconciled by measuring portfolio returns relative to the target (or benchmark) and then eliminating the usual assumption that the utility's risk-aversion parameter is not also determined by maximization of expected utility. Financial advisors should not be persuaded by advocates of the usual expected-utility approach.

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