Risk, Return, and Utility

Author(s): David E. Bell

Source: Management Science, Vol. 41, No. 1 (Jan., 1995), pp. 23-30
Published by: INFORMS
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Risk,

Return,

and

Utility

David E. Bell
Harvard Business School, Boston, Massachusetts 02163

xpected utility theory is widely acknowledged to be a rational approach to making decisions

involving risk. Yet the methodology gives no explicit role to measures of risk and return.
In this paper we identify those families of utility functions that are compatible with a riskreturn interpretation. From these families we deduce utility-compatible measures of risk.
(Risk; Return; Utility; Investments)

Introduction
In this paper we consider a person deciding among a
set of financial alternatives with uncertain payoffs. Each
alternative is summarized by a probability distribution
over cashflows that are incremental to a known initial
wealth. The results that follow may be adapted fairly
easily to cases where financial payoffs are multiplicative
rather than incremental, where initial wealth is itself
uncertain, or where the outcomes are not financial.
We will denote uncertain alternatives generically by
the notation x, y, z - *, and the base wealth by w. The
decision maker selecting x would then have uncertain
wealth w + x which, upon resolution, would lead to
some particular wealth w + x. For the case in which
an alternative x has two possible outcomes xi and x2,
with xl occurring with probability p, we will write
=

(Xl, p, X2)-

Von Neumann and Morgenstern (1947) showed that

if a decision maker accepts a certain set of assumptions
concerning "rational choice," then the decision maker
should compare alternatives by use of an expected utility
calculation. For some function u, which varies by decision maker, an alternative x should be preferred to an
alternative g if and only if Eu(x) > Eu(y), and be indifferent between them if and only if Eu(x) = Eu(y)).
The symbol E represents expectation over the underlying
probability distribution. For example, (xl, p, x2) should
be preferred to (yi, q, Y2) if and only if
pu(x1) + (1

p)u(x2)

> qu(yl) + (1

q)U(y2).

Because we wish to give an explicit role to the decision

maker's initial wealth, w, we will describe outcomes in

terms of final total wealth, so that x is to be preferred

to g if and only if Eu(w + x) > Eu(w + y). The beauty
of the expected utility approach lies in the elegance and
compelling nature of von Neumann and Morgenstern's
axioms. Though criticized and challenged over the last
50 years, their theory remains the benchmark economic
approach to such problems.
Their theory gives no explicit role, however, to the
concepts of risk and return. Informal discussion of alternatives by decision makers often includes statements
such as "alternative A is more attractive than alternative
B, but is too risky," suggesting that decisions are thought
of, at an intuitive level at least, as a tradeoff between
the risk inherent in the alternatives, and their levels of
"return"(their attractiveness were it not for the "risk").
The notion of risk as a distinct entity has been examined
extensively, although in ways at best loosely connected
with von Neumann-Morgenstern utility; see, for example, Markowitz (1959) and, for an axiomatic treatment of risk as a primitive, Fishburn (1984, 1982).
We suggest that a more intuitively satisfying model
than expected utility would recognize a measure of the
return r(x) and risk R(x) of an alternative. The tradeoff
between risk and return might well depend on the decision maker's wealth; we therefore propose an evaluation function of the form f (r(x), R(x), w), for some
risk-returnfunction f.
The purpose of this paper is to consider solutions to
the equation Eu(w + x) = f(r(x), R(x), w). We will
show that there is a surprisingly wide range of utility
functions that have a risk-returninterpretation. We give
special attention to the nontrivial subset of solutions

0025-1909/95/4101/0023$01.25
Copyright ? 1995, Institute for Operations Research

and the ManagementSciences

MANAGEMENT SCIENCE/VOl.

41, No. 1, January 1995

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23

BELL
Risk, Return, and Utility

satisfying desirable properties of u, r, R, and f. More

motivation for this inquiry can be found in ?7 of this
paper.

is reasonable to suppose that u (w) is continuous and

strictly increasing. These conditions imply that every
alternative x has a certaintyequivalent c(x, w), uniquely
defined by the equation

1. Illustrations

Eu(w + x) = u(w + c(x, w)).

(i) Suppose that a decision maker has a utility function

u(x) = -ecx, where c is a constant. We make the role
of initial wealth explicit by writing
u (w + x) =-e

-c(w+x) = _e -cw e -cx

The evaluation of an alternative x may be written as:

Eu(w + x)

exp(-cx))

E(-exp(-cw)

(-cw) E exp (-dcx)

=-exp

exp(-cx) E exp(-c(x-

=-exp(-cw)

x)).

Let
r(x) = x and

R()

=-log

E exp(-c(x-x)).

Then
f(r, R, w) =-e-cw

exp[-c(r

R)].

Thus the relation Eu(w + x) > Eu(w + y) may be

written equivalently, and suggestively, as r(x) - R(x)
> r(y) - R(g). My choice of definitions of r and R in
this example are not unique; however, they do result
from arguments presented later in this paper.
(ii) Suppose that a decision maker has a quadraticutility function
u(w + x) = a(w
=

aw2

+ X)2 +

b(w + x) + c

+ bw + c + 2awx + bx +

= u(w) + (2aw + b)x +

Let r(x, - x-and R(x) = E(x- X)2.
f(r, R, w)

aw2

U(w*

62)

U(w*

62 +

n(62

61))

for all integral n. Since arbitrarily small 61, 62 exist, u

must be constant.
If u is strictly monotonic, let p be the unique solution
to the indifference statement 1 - (2, p, 0 ); that is, u ( 1 )
= pu(2) + (1 - p)u(0). Then for all integers n we have
n + 1 - (n + 2, p, n), so that

ax2

u(n + 1) = pu(n + 2) + (1 - p)u(n)

or

ax2.

Then

+ bw + c + (2aw + b)r + ar2 + aR.

In this case, though the definitions of r and R seem

plausible, a consequence of the quadraticutility function
is that f is either increasing in R (if a > 0) or decreasing
in r (a < 0, w large).

2. Background
The axioms of utility impose no conditions on the shape
of the utility function, but for financial applications it

24

A person is termed riskaverseif c(x, w) < Ex = x for

all nonconstant x, and decreasinglyrisk averse if c(x, w)
increases with w.
The following result is well known. However, the
proof is new and forms the basis of other proofs that
follow.
RESULT 1. Suppose that if two alternatives are judged
to be indifferent at any one level of wealth, then they
will be judged to be indifferent at any other level of
wealth. If the utility function is continuous, then it is
either linear or exponential. That is either u(w) = aw
+ b or u(w) = a + becwfor some constants a, b, c.
PROOF. We will first show that if the condition stated
in the result is true, then u is either constant or strictly
monotonic. Suppose that u has a turning point at wealth
w *. If u is continuous, there must be nearby wealth
levels w* - 61 and w* + 62 such that u(w* - 61)
= U(w* + 62). But then

u(n + 2) = (1/p)u(n

+ 1) - ((1 - p)/p)u(n)

or

u(n + 2) - u(n + 1) = ((1 - p)/p)(u(n+l)-u(n)).

This simple recurrence relation has general solutions
u(n) = a + bn (if p = I ) and u(n) = a + b((1 p)/p)n
(otherwise) for some constants a, b, p. (Gray 1967,
Chapter 5, provides a review of solution techniques for
recurrence relations). Note that general solutions such
as these must hold for any choice of origin (w = 0) and
increments (what is chosen to constitute the unit interval). Continuity dictates that these solutions converge
to a + bw and a + becw,respectively.

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BELL
Risk, Return, and Utility

The following related result reviews and extends results from Bell (1988).
RESULT 2. The following four conditions are equivalent if u is continuous:
I. If two alternatives are judged to be indifferent at
any two wealth levels, then either they will be judged
indifferent at all wealth levels or u is of the form aecw
cos bw for some constants a, b, c.
II. u(w + x) = a(x)b(w) + c(x)d(w) + e(w) for some
functions a, b, c, d, and e.
III. u is differentiable and satisfies the differential
equation u"' = au" + bu' for some constants a, b.
IV. u belongs to one of the following five families of
functions:
(i) Linear plus exponential: aw + bec"',
(ii) Quadratic: aw2 + bw,
(iii) Sumex: aebw + cedw

(iv) Linear times exponential: (aw + b)ecw,

(v) Exponential cosine: aeczvcos bw,
where a, b, c, and d are arbitrary constants.
PROOF. Consider the equations:

(3, 1/(1 + k), 2)

(2, k/(l

+ k), 1).

If k is negative, then
(3, 1/(1 + k), 2) - (1, 1/(1 + k), 0).
If k is zero, then 2 - 0.
In summary, we have shown that there will always
be two gambles involving payoffs of 0, 1, 2, 3 that are
indifferent at the two wealth levels w = 0 and w = 1.
If the first part of condition I holds, they are then
indifferent for all w. Thus, generalizing (1) and (2) we
have for all n the recurrence relation
u(n + 3) = (q/p)u(n + 2)
-

((1 - p)/p)u(n + 1) + ((1 - q)/p)u(n).

(3)

(If p = 0 the recurrence relation is one order lower and

u is linear. Equation (3) also holds for the exponential
cosine.)
The general recurrence relation
u(n

+ 3) = alu(n + 2)

a2u(n + 1)

a3u(n)

(4)

= (u(4) - u(2))/(u(3)
- u(1)) = k
say. In the case where k is positive, we have

has one of the following solutions (Gray 1967, p. 126),

where z1, Z2, and Z3are roots of the equationz3 = a1z2
+ a2z + a3:
(i) b1z"+ b2zn + b3z3 if all roots are distinct,
(ii) b1zl + (b2n + b3)z2 if z2 = z3, or
(iii) (b1n2 + b2n + b3)z if z1 Z2 = z3 for all n.
Since a1 + a2 + a3 = 1 (compare (3) and (4)) at least
one of the zi is equal to 1. As with Result 1, a recurrence
relation such as (4) may be deduced for arbitraryorigins
(where w = 0), and using arbitrarily small intervals
(not just integers). As the intervals tend to zero the
recurrence relations converge, respectively, to
(i) aebw + cedw or aecw cos bw,
(ii) (aw + b)ecw or aw + becw,or
(iii) aw2 + bw, or (aw + b)ecw.
For example, in (ii) the first case arises if z1 = 1, the
second if z2 = 1. The cosine solution arises from the
possibility of imaginary roots of the cubic equation. We
have shown that I implies IV.
It is straightforward to check that the functions in IV
satisfy conditions I, II and III. That III implies IV is routine (see, for example, Piaggio 1965, p. 25). To see that
II implies an equation such as (4) (which then implies
IV), note that II may be written as (substituting n for
w and k for x)

MANAGEMENTSCIENCE/VOL.41, No. 1, January 1995

25

pu(3) + (1 - p)u(l) =qu(2) + (1 - q)u(O)

(1)

and
pu(4) + (1 - p)u(2) = qu(3) + (1 - q)u(1).

(2)

If these equations have a solution with p and q

between 0 and 1, then we have found two gambles
(2, q, 0) and (3, p, 1) that are indifferent at both w
= 0 and w = 1. (Such solutions will exist if u is increasing.) Even p, q solutions outside the 0 - 1 range represent equivalent gambles. For example, if a solution is
p = -2 and q = 2, then we have
-2u(3) + l-u(l)

= 2u(2)

or

lu(O)

lu(O) + 1lu(1) = 2u(2) + lu(3)

or (1, 3, 0)
(3, 1, 2).
No unique solution to (1) and (2) exists if and only
if
(u(3)

U(1))2

= (u(4)

u(2))(u(2)

u(0))

or
(u(3)

u(1))/(u(2)

- u(0))

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BELL
Risk, Return, and Utility

u(n + k) = a(k)b(n) + c(k)d(n) + e(n).

Let k equal, in turn, 0, 1, 2, and 3. The first 3 of these
equations may be solved for b(n), d(n) and e(n) and
substituted into the fourth to obtain a recurrencerelation
such as (4). (If the first 3 equations are collinear this
implies a lower order recurrence relation.) But, as argued
at the beginning of this proof, an equation such as (4)
must, in fact, be of the form (3). 0

ferent at two wealth levels w1 and w2 only if R(x)

= R(g). But since f is strictly increasing in r, this also
implies that r(x) = r(g). But then x must be indifferent
to y for all w. This means that condition I of Result 2
holds. Hence u must belong to one of the five families
cited in IV. The only functions in IV that satisfy the
conditions on u for all w are those stated in the theorem.
Indeed, families (ii), (iv), and (v) of IV are increasingly
risk averse for all w for all choices of constants.

3. Risk-return Functions
Implications for risk-return functions are fairly immediate from Result 2. In this section we describe the main
conclusions regarding such functions. In the next section
we examine the implications for measures of risk and
return. Finally, in ?5 we present some variations on the
theorem in this section.
To review, we seek functions u, f, r, and R such that
Eu(w + x)

f(r(x), R(x), w).

What are some reasonable properties of these functions?

In this section we will consider properties of u and f.
In the next section we will consider reasonable properties of r and R. The following assumptions seem to
be the most analogous to those commonly assumed
about u:
ASSUMPTION 1. More money is better than less. We
assume that u strictly increases with w and that f strictly
increases with r(x). That is, more return is better.

2. Risk aversion. We assume that u is

risk averse and that f strictly decreases with R(x). That
is, more risk is worse.
ASSUMPTION

ASSUMPTION 3. Decreasing risk aversion. We assume

that u is decreasingly risk averse. Forf, we assume that if

x - y at w thenx > y at highervaluesof w if andonly if

R(x) > R(y). That is, risk becomes less of a liability as w
increases
THEOREM 1.

Suppose u is continuous. Then if

Eu(w + x) = f(r(x), R(x), w),

4. Measures of Risk and Return

If u(w) = w

becw then

Eu(w + x) = w +

x-

be-zE exp(-cx).

Certainly there would be some charm to assuming r(x)

= xand R(x) = E exp(-cx), for then
Eu(w + x) = w + r(x)

becwR(Y).

However, though r(x) = x seems reasonable enough,

R(x) = E exp(-cx), for me at least, is not. It suggests,
for example, that the risk of receiving $5 is less than
the risk of receiving $4. I think that the riskiness of a
sure thing should be zero.
If we let r(x) = x-and R(x) = E exp(-c(x - x)) - 1,
then in the case u(w) = w - be-"' we may write

Eu(w + x)
= w + x- becw exp(-cx)
= w + r(x)

= u(w + r(x))

becw exp(-cx)R(x)

becw exp(-cr(x))
-

be-(w+r)R(f)

be-(w+r)R(x).

This last representation is not without charm either

and involves (to my mind) a more reasonable definition
of risk. The purpose of the current and next sections is
to state explicit conditions on the forms of r(x) and R(x)
and derive their implications. We will consider, in turn,
the implications of the following restrictions on the risk
and return functions.
ASSUMPTION1 (RETURN).

Thereturnof thealternative

and if u and f reflect increasing appreciationfor wealth,

riskaversionand decreasingriskaversion, then either u(w)
= w - becw or u(w) = -e-aw - be-cwwhere a, b, c are
arbitrarypositive constants.

(x, p, g) is continuousin p.

The decreasing risk aversion assumption

implies that two alternatives x, y can be judged indif-

It seems to me that if we expect our overall preferences

to satisfy the axioms of utility, the concept of return,

PROOF.

26

ASSUMPTION2 (RETURN).

Thereturnfunctionsatisfies

the axioms of utility.

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BELL
Risk, Return, and Utility

which is in some sense a simpler concept (in that "risk"

has been removed as an issue), should do so also. Both
these assumptions, however, would rule out the use of
the median, for example, as the measure of return.
ASSUMPTION

(RETURN).

The returnfunction is the

mean.

and u(w) = -e -a - be-w for positive constants a, b,

and c (with c > a).
Each definition of r is unique up to positive linear transformations. Each definitionof R is unique up to an arbitrary
strictly increasing transformation.
The proof is similar for the two cases. We
will demonstrate the more difficult case in which u (w)
= -e-aw - becw and
PROOF.

This assumption could be stated more subtly by saying that in addition to Assumption 2, the return function
is risk neutral. Note that Assumption 3 is stronger than
Assumption 2 which is stronger than Assumption 1.
4 (RISK). The riskiness of an alternative
depends only on the decision maker'sfinal distribution of
wealth. That is, R(x) = R(w + x).
ASSUMPTION

We have already assumed that the risk of an alternative is independent of initial wealth; it is the reason
we may write R(x). We also know that the riskiness of
a final distribution of wealth, w + x, is independent of
the particular division of w + x between initial wealth
and the alternative (because R(w + x) = R(w + k + x
- k)). Assumption 4 adds the idea that all alternatives
that lead to the same distribution of final wealth (assuming constant initial wealth) have the same riskiness.
An initial wealth of w - k and alternative x + k leads
to the same distribution of final wealth as an initial
wealth of w and an alternative Y. Assumption 4 says
R(Y + k) = R(Y). A corollary of this assumption is that
all constant payoffs have the same risk. Assumption 5
is a little more specific.
5 (RISK). The risk of an alternative is
positive if and only if its outcome is uncertain. Otherwise
it is zero.
ASSUMPTION

Note that this assumption is implicit in our usual understanding of risk aversion. Our definitions for decreasing risk aversion for u and f (see previous section)
are consistent only in the context of Assumption 5.
THEOREM 2. Given the conditions of Theorem 1, consistency with assumptions 2 and 4 requires that either
and
(i) r(x) =x, R(x) = (llc) log Eexp(-c(x-x)),
u (w) = w - be-"' for positive constants b and c, or
(ii) r(x) = -E exp(-ax),

R(x) = (1/c) log E exp(-c(x-x))

-

(1 /a) log E exp(-a(x-x

MANAGEMENT SCIENCE/VOL

))

Eu(w + x) = -e-awE

exp(-ax)

becwE exp(-cx).

For some functions h, and h2 we must have

r(x) = hi(E exp(-ax),

E exp(-cx))

R(x) = h2(E exp(-ax),

and

E exp(-cx)).

Since r is a utility function we know that

E exp(-cx))

hi(E exp(-ax),

equals the expectation of hi (exp (-ax), exp (- cx)), and

hence h, must be linear in its arguments. That is,
r(x) = aE exp(-ax) + fE exp(-cx)
for some constants a, 0.
Now consider a case in which x is a constant, say x
-k. We have r(k) = aeak + fe ck. By assumption 4,
R(k) is independent of k. Also u (w + k) is monotonically
increasing both in k and in r. So it must be that r is
monotonically increasing in k. (We might reasonably
have assumed that directly!) This implies that a and:
are each nonpositive.
But now consider an uncertain alternative x for which
r(x) = r(k). Thus,

aE exp(-ax) + f3Eexp(-cx)

= aeak + 1e-ck.

(5)

Since r(i1) = r(k), the preference ordering of x and k

must be the same for all w. That is,
-e-aw[E exp(-ax)-e

-ak]

-becw[E

exp(-cx)

e-ck]

has constant sign for all w. By consideration of extreme

values of w we see that this means that the signs of

E exp(-ax)-e

-ak

and

E exp(-cx)

e-ck

must be equal. But this is inconsistent with (5), unless

one of a and : is zero. Thus either
r(x) = -E exp(-ax)

or r(x) = -E exp(-cx).

41, No. 1, January 1995

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27

BELL
Risk, Return, and Utility

We argue that if c > a then r(x) = -E exp(-ax). The

assumption of decreasing risk aversion for / requires
that if two alternatives x, y are indifferent at w, then
for levels of wealth above w, x is preferred if and only
if R(x) > R(y) or, equivalently, if and only if r(x)
> r(y).
Suppose x - y at w. Then
exp(-ax)

-e-azw(E
-

R is arbitrary up to positive transformation we may as

well assume R = S. Thus
Eu(w + x) = re-"'

becw(E exp(-cx)

R(x)
= 0.

E exp(-cg))

log E exp(-c(x-x))

(/c)

Eu(w + ) = w + rbe-ce-

If c > a then x will be preferred to y for wealth levels

above w if
> -E exp(-ay)

-E exp(-a)
-E exp(-cx)

and

< -E exp(-cg).

If r(x) = -E exp(-ax) then the first of these two inequalities is consistent with decreasing risk aversion. If
r(x) = - E exp (- cx) then the second inequality is not.
Hence r(x) = -E exp(-ax).
Now let us consider
R(x) = h2(E exp(-ax),

E exp(-cx)).

This may be written, equivalently, as

R(x) =

(1/a) log E exp(-a(x-x-),

h3(y-

(1/ c) log E exp(-c(x-x))

-

(1/a) log E exp(-a(x- x)).

We will show that h is strictly increasing, and thus we

may assume R(x) = S (). As a matter of identity we
have
E exp(-cx)

exp(cS(x))(E

exp(-aY))c/a.

We may therefore write

Eu(w + ) = re -aw

be-CU(-r)

c/a

e cs

From this equation we can see that, for fixed r, Eu

strictly declines with S, and by assumption, Eu strictly
declines with R. Hence R increases strictly with S. Since

28

and

-crecR

be-C(u?+r-R).

5. Discussion
The definitions of R(x) that emerge from Theorem 2
also satisfy Assumption 5. For example, if x is normal,
N(,u, '2), then if u(w) = w - be-Cu'we have r(x) =
and R(x) = ' cou2.If u(w) = e-aw - be-Cw then
r(x) =-exp(-a(,t-I

au2)

and R()

(c-a)o-2.

Because the normal distribution has such prominence,

and because the variance is widely used as a measure
of risk, there is some merit to adapting our definitions
of risk, in a minor way, to
R(x) = (2 / c2) log E exp(-c(x-

Assumption 4 implies that h3(x, y) = h3(x - y, 0).

Hence we may write, for some function h, R(x)
= h(S(x)) where
S(x)

= w + r-

(1/c) log E exp(-c(x-x)

x-

r)C/aecR

In the case where u(w) = w - be-cw, the argument

is very similar, but leads to the conclusions that
r(x) = x,

E exp(-ay))

be-cw(

R(x)

(2/(c

a))[(1/c)
-(1/a)

f))

and

log E exp(-c(x-

x))

log E exp(-a(x-x)

respectively.
For nonnormal distributions, these definitions are
seemingly more complex than the variance. In this age
of spreadsheets, however, this is not really an impediment to their use. One major difference is that they do
depend on parameters (c and a) that vary by individual.
This means that we cannot talk about the risk of an
alternative for all people. In the simpler definition of
R(x), the parameter c controls the degree to which our
concern about risk is due to extreme downside outcomes
rather than simply spread. If c is close to zero, then the
risk measure approximates the variance which gives
equal weight to upside and downside spread. As c gets
large, the risk measure simply reflects "worst case" outcomes.

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BELL
Risk, Return, and Utility

6. Related Results
The proof of Theorem 1 made substantial use of the
decreasing risk aversion concept as applied to f. On the
other hand, we made no use of conditions about the
nature of r(x) and R(x). In this section we relax the
decreasing risk aversion condition on f and instead use
some of the assumptions about risk and return from
the last section.
In this first result, we make explicit the desire to have
r(x) be the mean.
THEOREM 3. If u is continuous and has a continuous
derivative, then Eu(w + x) is consistent with a risk-return
function f(r(x), R(x), w) that is strictly increasingin r(x)
and strictly decreasingin R(x) and where r(x) = x, if and
only if u belongs to the linear plus exponential family or
the quadraticfamily. If, for all w, u(w) is to be strictly
increasing and risk averse, then u(w) = aw - be-cv for
some nonnegative constants a, b, c.
PROOF. Since r(x) = x, any two alternatives having
the same mean will have the same preference ordering
for all w, since preference will then depend only on
relative riskiness.
If x and y have the same mean, then consider deriv,
and Z2= (X, 2', Y + 6)
ative gambles Z1= (x + 6, 2y)
where 6 is a small amount. Note that z1 and Z2 also have
the same mean. Thus the quantity

[2Eu(w

+h x + ) +

Eu(w +)]

_-[21

Eu(w + x) +

Eu(w + y + 6)]

has the same sign for all w. Rewriting twice this quantity
as
[Eu(w + x + 6)
-[Eu(w

Eu(w + x)]

+? y + )-Eu(w

+)]

we note that this too has constant sign for all w. Now
consider the function v (w) = u (w + 6) -u (w). Viewing
v as a utility function in its own right, we see that the
quantity Ev(w + x) - Ev (w + y) has constant sign for
all w.
By Result 1 this means that v (w) must be linear or
exponential in w. By choosing 6 small enough and invoking continuity we see that the derivative of u must
be linear or exponential in w. Integrating the linear case

MANAGEMENT SCIENCE/VOL.

gives us a quadratic utility function; integrating the exponential gives us a linear plus exponential utility function.
Though the quadratic can be increasing and risk
averse on an interval of w, it never has these properties
for all w. O
THEOREM 4. Suppose that u is continuous, increasing,
and risk averse for all w. If Eu(w + x) is consistent with
a risk-returnfunction f(r(x), R(x), w), strictly increasing
in r(x), strictly decreasing in R(x) and where r is itself a
utility function, then either u (w) = aw - be-cz or u (w)
= -e-azv - be-c" for some nonnegative constants a, b, c.
PROOF. Consider solutions in p, q to the equations
u(3, p, 1) = u(2, q, 0) and r(3, p, 1) = r(2, q, 0). If
such p and q exist then it must also be that R(3, p, 1 )
= R(2, q, 0). Hence (3, p, 1)
(2, q, 0) for all w. But
then we obtain the recurrence relation (4) used in Result
2. But since r(x) is assumed to be a utility function,
solutions in p and q must exist, for we have

pu(3) + (1

p)u(l)

= qu(2) + (1

pr(3) + (1 - p)r(l) = qr(2) + (1

q)u(O)
-

and

q)r(O).

The only dilemma occurs if there is no unique solution

to these equations for any choice of w. But this implies
that u(w + x) = a + br(x) for some constants a, b,
which implies that u is linear or exponential. [H
In Theorem 3 we used Assumption 3 about r(x); in
Theorem 4 we used Assumption 2. Now we assume
only Assumption 1 but add Assumption 5 about R(x).
Suppose that u is continuous, increasing,
and risk averse for all w, and that Eu(w + x) is consistent
with a risk-returnfunction f (r(x), R(x), w) which is increasing in r(x) and decreasingin R(x) for all w. Suppose
that r(x, p, y) is continuous in p and that R(x) is positive
if and only if x is uncertain, and zero if and only if x is
constant. Then either u (w) = aw - bec-cvor u (w) =-e -aw
- becw for some nonnegative constants a, b, c.
THEOREM 5.

As in Theorem 4 we try to establish the

PROOF.
existence of solutions p, q to the equations
u(3, p, 1) = u(2, q, 0)

and

r(3, p, 1) = r(2, q, 0).

We know that there must exist values p*, q* between

zero and one such that

41, No. 1, January 1995

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All use subject to JSTOR Terms and Conditions

29

BELL
Risk, Return, and Utility

(3,p*, 1)

(2, 1,0)

and

(3,0, 1) - (2,q*,0).

By Assumption 5 we know that

R(3, p*, 1) >R(2,

1, 0),

and therefore
r(3, p*, 1) < r(2, 1, 0).
Also by Assumption 5, we know that
R(3, 0, 1) < R(2, q*, 0)
and therefore that
r(3, 0, 1) > r(2, q*, 0).
Now, for a range of probabilities, X, consider the two
compound gambles
((3,p*,1),X,(3,0,1))

and

((2,1,0),X,(2,q*,0)).

For all X, these two have the same utility. For X = 1 the
first has the higher return; for X = 0 the second has the
higher return. By Assumption 1, continuity of r, there

This paper shows that there is another way to gain a

second-order approximation. Moreover, it is one that
meets the rationality concerns of utility theorists on the
one hand, and our intuitive concepts of risk and return
on the other.
Consider the virtues of the utility function u (w) = w
- be-cw, where b and c are positive constants. It is increasing in w, risk averse, and decreasingly risk averse.
Alternatives may be compared by use of a risk-return
function with return measured by the mean. The parameters b and c leave considerable flexibility to match
personal attitudes to what constitutes relative riskiness
(the parameter c) and of aversiveness to that riskiness
(the parameter b).
It is my belief that these properties of u (w) = w
- be-cw (and others explained in Bell 1988 and 1993)
are sufficiently compelling that it could be adopted as
the generic utility for wealth in assessments and economic analyses.

exists a value of X, X*,at which they have the same

References

return. Set p = p*X* and q = X* + q*(1 - X*). Now

proceed as in the proof of Theorem 4. O

Bell, D. E., "One-Switch Utility Functions and a Measure of Risk,"

ManagementSci., 34 (1988), 1416-1424.
"Contextual Uncertainty Conditions for Utility Functions,"
Harvard Business School Working Paper No. 94-044, 1993.
Forthcoming in Management Sci.
Fishbum, P. C., "Foundations of Risk Measurement. I. Risk as Probable
Loss," Management Sci., 30 (1984), 396-406.
,"Foundations of Risk Measurement. II. Effects of Gains on Risk,"
J. Mathematical Psychology, 25 (1982), 226-242.
Gray, J. R., Probability, Oliver and Boyd, Edinburgh, Scotland, 1967.
Markowitz, H., Portfolio Selection, John Wiley and Sons, New York,
1959.
Piaggio, H. T. H., Differential Equations, G. Bell and Sons, London,
England, 1965.
Von Neumann, J., and 0. Morgenstern, Theoryof Gamesand Economic
Behavior (second edition) Princeton University Press, Princeton,
NJ, 1947.

7. Discussion
One may think of the linear utility function and its associated statistic, the mean, as first-orderapproximations
to the "truth" of nonlinear utility. Historically the
second-order approximation to utility has been the
quadratic, along with its associated statistics of mean
and variance. But the quadratic utility function is disliked by those who believe in sensible global properties,
such as increasing appreciation for wealth, risk aversion,
and decreasing risk aversion.

Accepted by Irving H. LaValle,formerDepartmentalEditor;received September11, 1991. This paper has been with the author 5 monthsfor 2 revisions.

30

MANAGEMENTSCIENCE/VOL41, No. 1, January 1995

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