Certainty Equivalent in Portfolio Management

In portfolio selection, strategies on an efficient frontier have been regarded as nondominated solutions because of the compensation to each increase unit of risk, and a rational decision maker has to consider other supplementary decision rules. This paper proposes an approach that helps a rational decision maker identify the best candidate strategy on an efficient frontier by taking the concept of certainty equivalent from decision analysis. It is shown that by integrating the efficient frontier and an approximation of certainty equivalent based on the widely used exponential utility function in the same coordinate plane, we are able to derive an analytical solution to the optimal strategy, and thus develop an efficient selecting procedure that can significantly reduce the computational load as a result of the necessary comparisons between only one or two candidate portfolios.