Statistical Science

Mean–Variance and Expected Utility: The Borch Paradox

David Johnstone and Dennis Lindley

Full-text: Open access

Abstract

The model of rational decision-making in most of economics and statistics is expected utility theory (EU) axiomatised by von Neumann and Morgenstern, Savage and others. This is less the case, however, in financial economics and mathematical finance, where investment decisions are commonly based on the methods of mean–variance (MV) introduced in the 1950s by Markowitz. Under the MV framework, each available investment opportunity (“asset”) or portfolio is represented in just two dimensions by the ex ante mean and standard deviation $(\mu,\sigma)$ of the financial return anticipated from that investment. Utility adherents consider that in general MV methods are logically incoherent. Most famously, Norwegian insurance theorist Borch presented a proof suggesting that two-dimensional MV indifference curves cannot represent the preferences of a rational investor (he claimed that MV indifference curves “do not exist”). This is known as Borch’s paradox and gave rise to an important but generally little-known philosophical literature relating MV to EU. We examine the main early contributions to this literature, focussing on Borch’s logic and the arguments by which it has been set aside.

Article information

Source
Statist. Sci., Volume 28, Number 2 (2013), 223-237.

Dates
First available in Project Euclid: 21 May 2013

Permanent link to this document
https://projecteuclid.org/euclid.ss/1369147913

Digital Object Identifier
doi:10.1214/12-STS408

Mathematical Reviews number (MathSciNet)
MR3112407

Zentralblatt MATH identifier
1331.91078

Keywords
Mean–variance expected utility Borch’s paradox probability mixture portfolio theory CAPM

Citation

Johnstone, David; Lindley, Dennis. Mean–Variance and Expected Utility: The Borch Paradox. Statist. Sci. 28 (2013), no. 2, 223--237. doi:10.1214/12-STS408. https://projecteuclid.org/euclid.ss/1369147913


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