4. Utility Function Approach

In the context of decisions under uncertainty investors try to maximize the expected return on investment and minimize investment risk. Unfortunately, there is a trade-off between these two aims. The theory of the choices under uncertainty leads the decision-making process in capital markets. The aim is to analyse the behaviour of the rational investor under uncertainty. Specifically, the aim of the theory is not to define a set of criteria for the investor’s preference for general validity because all investors are different from one another. Otherwise, the aim of the theory is to define a set of criteria of the decision-making process based on a few principles characterized by generality, rationality, economic significance, consistency with individual criteria, and therefore able to have a normative function. In this regard, the theory defines the criteria by which the rational investor chooses between the real possible options, considering the restrictions, on the basis of the expected effects that could be achieved according to their nature and that can be sorted in consideration of the relative probability. The portfolio choices (or portfolio selection) is a problem related to wealth allocation between different investment assets. In this context, the portfolio choices will be analysed based on the two main criteria:

This chapter analyses the first criteria, while the next chapter analyses the second criteria.