Stochastic Dominance Decision Rules

Abstract

We have seen that the MEUC is the optimal investment criterion. If there is full information on preferences (e.g., U(w) = log (w)), we simply calculate EU(w) of all the competing investments and choose the one with the highest expected utility. In such a case, we arrive at a complete ordering of the investments under consideration: there will be one investment which is better than (or equal to) all of the other available investments. Moreover, with a complete ordering, we can order the investments from best to worst. Generally, however, we have only partial information on preferences (e.g., risk aversion) and, therefore, we arrive only at a partial ordering of the available investments. Stochastic dominance rules as well as other investment rules (e.g., the mean-variance rule) employ partial information on the investor’s preferences or the random variables (returns) and, therefore, they produce only partial ordering.