The Mean-Variance Rule for Investors with Reverse S-Shaped Utility

Abstract

Our paper contributes to the literature by developing the theory of the mean-variance (MV) rules for investors with reverse S-shaped utility. To do so, we first introduce the definition of the MV rule for investors with reverse S-shaped utility. We then set up the conjecture on the preference for different prospects by using the new MV rule that they could get a higher expected utility for the preferred asset under some conditions. Thereafter, we look for the conditions that the conjecture could hold and construct a theorem for this purpose by showing that when the negative (positive) parts of the assets follow one (another) type of location-scale family or the linear combination of location-scale families, then the preferences of the assets is the same as those by using an expected utility for the investors with reverse S-shaped utility. We then extend the theory by developing some properties of portfolio diversification by using the new MV rule. The theory developed in our paper enables academics and practitioners to apply the theory developed in this paper to analyze some important empirical issues and draw inferences on the preferences of investors with reverse S-shaped utility.