# Why do we assume quadratic utility in portfolio theory?

In my text (Investments by BKM), the investor's mean-variance utility (given as $U = E[R] - \frac12A\sigma^2$) is stated to be the objective function we wish to maximize. Upon further digging, it seems that this stems from the assumption of quadratic utility functions ($U = aW - bW^2$). This kind of bothers me since I see two unrealistic properties for quadratic utility functions. (1) They exhibit increasing absolute risk aversion, and (2) they achieve a satiation point, beyond which money/return begins to have negative value.

So why do we assume quadratic utility? Are there no other simple, more realistic functional forms for utility that would still lead to a reasonably clean portfolio optimization theory? Or are the issues I cited about the quadratic just negligible in practice?

• If utility is quadratic then we can do optimization on it. So it is convenient to have quadratic function. – i squared - Keep it Real Apr 30 '16 at 13:10

In most settings, utility functions are defined up to an affine transformation: if $u(x)$ defines the preference of an investor, then so does $a*u(x)+b.$ This implies, you can normalize the Taylor expantion of any smooth utility function to $u(x)=x+a*x^2+\ldots$ around 0. So the next step is just to drop off higher order terms. The investor is also usually assumed to be risk-averse, which implies, that $a < 0.$ You can check the details, e.g. here: https://www.empiwifo.uni-freiburg.de/lehre-teaching-1/winter-term-10-11/materialien-portfolio-analysis/utility.pdf