| The slides in the file are shown below. The first 4 slides
deal with the belief that financial planning, as well as defined benefit plans, deal with
a liability stream in the future. To meet those liabilities as they come due requires some
mimimal rate of return on the assets. Traditional theory assumes
uncertainty is bell shaped and that the past is connected to the future by a straight line
(a regression line). We at PRI use concepts developed subsequent to the CAPM.
The last few slides deal with formal ways of making choices under conditions of
uncertainty. Beginning with the slide titled "How Do Models Find"the
optimal portfolio. One way to locate the optimal portfolio on the efficient frontier
is to use a utility function. The next slide shows the quadratic utility function,
which becomes pathalogical at some point, i.e., investors hate making more money and start
giving it away. The next slide shows the Fishburn utility function which describes
an investor who is risk averse for returns below the MAR and risk neutral for returns that
fall above. The next slide superimposes the S curve of prospect theory on the
Fishburn utility function. The S curve depicts how people actually behave, i.e.,
they become risk takers for investments that have a small chance of very bad
outcomes. Recent news concerning Indonesia and Long Term Capital are examples of
what can happen to such investors. S-type investors also become risk averse to very
high returns. An example would be selling covered call options.
The next few slides are related to our current research which recommends a
marraige of behavioral finance and normative utility theory to produce the value function
that maximizes the upside potential of an investment for a given level of downside risk.
A performance measure that is consistent with this view is the U-P ratio.
Explanations for the most of the other graphs can be found in articles
found elsewhere on this web site. I hope this helps you to explain these concepts.
Please let me know if there is something else I can do to assist you in educatiing
others.
 
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