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Received 5 September 2003.

Abstract

This paper responds to three questions not well answered for many students of finance: (1) How do investors choose where to aim on an efficient frontier of trade-offs between portfolio expected return and risk? (2) What do investors do when return variance is inadequate as a summary of risk? (3) How can investors take into account the need to avoid interim shortfalls on the way to a more distant goal? To have great impact, the answers must be simple enough to be carried in the heads of practical investors. Since vivid examples help, the last part of this paper examines five cases: the option income fund, extreme CPPI (Constant Proportion Portfolio Insurance), the Long-Term Capital Management case, the Enron case and split capital trust funds. In each case, the discretionary wealth hypothesis is used, a reformulation of what are sometimes known as fractional Kelly strategies, to pinpoint the easily remedied blind spots that led to unexpected disappointments.