Question

Compare and contrast Expected Utility Theory and Portfolio Theory as descriptions of how decisions are made under conditions of risk. What are their main similarities and differences?

Answer 1

Expected Utility & Portfolio Theory
Expected utility theory states that, under uncertainty, the utility at any given point of time will be well represented by taking the weighted average of all possible level of utility. The theory helps analyzing a situation where an individual is not certain about the outcome of a particular decision. People under risk will choose the action that will result the highest expected utility, which is the sum of the product of probability over all possible outcomes. With expected utility people act accordingly to avoid the risk and attain possible maximum level of expected utility. The theory makes example of people being insured over risks which even leads to lose money for the time being, but expected to a utility that the policy gives over if the individual face an accident. That is, the high expected utility from insurance helps individuals to take decision whether to be insured or not, observing the risk that he or she may face.
Portfolio theory refers to the concern of investors on the expected value of securities and the interest in expected value of portfolio. The theory suggests about minimizing risk and maximizing expected returns over investment. Investors are suggested to invest in the security which gives maximum expected return. The theory helps the investors to avoid chance of risk by not investing in securities that give less expected return or utility.
Both Expected Utility and Portfolio Utility refer to the concept of avoiding risk and maximizing expected utility. Expected Utility while referring to the risk that may incurred by individuals and firms in uncertainty, the latter suggest to maximize the return of investors by investing on securities to avoid the loss on expected returns.