Behavioural finance Essay Example | Topics and Well Written Essays - 2000 words

Behavioural finance - Essay Example Incurring of additional risk helps attain high rates of return. There has been a proposal relating to the utility maxim and the general solution for the portfolio selection problem (Von Neumann and Morgenstern, 2007). The process of making an investment choice includes; choosing a unique optimum combination of risky assets and separate choice regarding to the allocation of funds. To obtain a maximum resulting satisfaction, there is combination and application of certain wants and commodities. The weakness of this model is it’s cumbersome to separate the purely technical from the ones in the conceptual nature. According to Mr. Jack Treynor, the total utility function can be given by U = f (E, a) illustrating the meters of distribution and the expected value and the standard deviation, where E indicates the future wealth and a shows the standard deviation under prediction (Markowitz, Miller & Sharpe, 1991). There is the preference of a high expected future wealth to a value which is low; this is known as ceteris paribus illustrated as (dU/dEw > 0). This leads to an upward slope as seen in the earlier graph of risk against the expected rate of return. For a simpler analysis, there is an assumption that an investor decides to commit an amount (W) of their wealth to investment. By letting R be the rate of return and W as the terminal wealth, then; R= (Wt- Wi)/Wi. The mean-variance under certain conditions leads to unsatisfactory predictions of behaviour. A model based on semi-variance is preferable basing on standard deviation and variance (Markowitz, Miller & Sharpe, 1991). There is an assumption that the curves can diminish marginal rates of substitution between E and ÃŽ ±, from the earlier equations. There is a derivation of indifference curves from the assumption that the investor wishes to maximise the expected utility and thus,