Portfolio Choice in the Model of Expected Utility with a Safety-First Component

Abstract

Whereas the majority of economists interpret risk as dispersion or variation in an outcome variable, many everyday decision makers tend to associate risk with the outcome failing to meet a certain “safety� level. In this model, a decision maker’s concern about the final wealth distribution per se is captured by the expected utility of the final wealth, and his concern about meeting a safety wealth level is captured by the probability of final wealth exceeding the safety level. The model finds that a positive expected excess return remains sufficient for investing a positive amount in the risky asset except in the special situation where the safety wealth level coincides with the wealth obtained when the entire initial wealth is invested in the riskless asset.