The F-Utility of Wealth: It’s All Relative

Abstract

Finance theory is based on a very simple, yet critical assumption that “individuals maximize the expected utility of wealth”. However, there are three crucial elements of this simple 6-word phrase that do not really stand the test of what investors actually do and one could argue, that the incorrect use of Modern Portfolio Theory (MPT) has led to the looming global retirement crisis. First, investors care about relative wealth (i.e., wealth relative to a goal) rather than absolute wealth, popularly called “Goals-Based Investing”. Second, individuals (or principals) are not always the ultimate decision makers — rather, many investment decisions are delegated to agents, which distorts behavior. Third, and most crucially, most investors do not appear to focus on utility functions, but rather seek to maximize risk-adjusted return. Instead, finance theory should start with the assumption that “investors delegate to maximize relative risk-adjusted returns.” This paper seeks to show how incorporating these three simple and completely realistic changes impacts asset pricing, asset allocation and the correct use of risk-adjusted performance measures. While the initial step requires a re-think of finance theory and models, the more urgent goal is to ensure retirement security as this new approach leads to financial innovation, better regulation and potentially better retirement outcomes.