Chapter 5

Risk Aversion and Investment Decisions, Part 1

In this chapter we operationalize the characterization of risk aversion presented in earlier chapters in order to study the two most important decisions an investor must make. The first is his portfolio composition decision: what are his relative demands for assets of different risk classes and, in particular, his demand for risk-free versus risky assets? The second concerns the investor’s consumption-savings decision: how much of an investor’s current income should he allocate to savings and how much to consumption? The standard expected utility preference characterization is also expanded to provide for the separation of time and risk preferences and to allow for preference in the timing ...

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