Please refer to <> Exhibit 16 Markowitz Portfolio Theory is most accurately describes that investor utility curves demonstrate diminishing utility of wealth. I don’t see/understand diminishing utility of wealth in utility curve. If I increase one unit of risk and return increases by more than one unit on all utility curves… I am sure I am missing something… It would be great if someone shed some light on this?
The diminishing marginal utility of wealth shows the trade off between risk and return. One of the assumptions of Markowitz’s portfolio theory is that investors are risk averse, meaning investors are willing to accept higher level of return for higher level of risk. As a result, the investor’s marginal utility of wealth is upward sloping. For each person, his or her marginal utility of wealth will be different. Therefore, the shape of the marginal utility curve and the location of the curve on the efficienct frontier curve will be different. For one investor, this curve might be very steep, which is a very risk averse individual (because this person is only willing to take it minimal risk for a high level of return) while for another the curve may be flat (willing to take on more risk for more return). In other words, the risk adjusted return (or unit or risk versus unit of return) will be different for varying shapes of the diminishing marginal utility of wealth. I hope this helps!