Pessimistic Portfolio Choice with One Safe and One Risky Asset and Right Monotone Probability Difference Order

Abstract EN

As is well known, a first-order dominant deterioration in risk does not necessarily cause a risk-averse investor to reduce his holdings of that deteriorated asset under the expected utility framework, even in the simplest portfolio setting with one safe asset and one risky asset.

The purpose of this paper is to derive conditions on shifts in the distribution of the risky asset under which the counterintuitive conclusion above can be overthrown under the rank-dependent expected utility framework, a more general and prominent alternative of the expected utility.

Two new criterions of changes in risk, named the monotone probability difference (MPD) and the right monotone probability difference (RMPD) order, are proposed, which is a particular case of the first stochastic dominance.

The relationship among MPD, RMPD, and the other two important stochastic orders, monotone likelihood ratio (MLR) and monotone probability ratio (MPR), is examined.

A desired comparative statics result is obtained when a shift in the distribution of the risky asset satisfies the RMPD criterion.