Formulating appropriate utility functions and personal financial plans

Abstract

Without inflation protected pensions, people need decision making tools (financial calculators) to make informed decisions about savings and investment for retirement. For investment, they need a framework to trade off risk and return. This paper examines the assumptions underlying some of the common utility functions in the financial literature and suggests ways of making them more consistent with the behavioural and happiness literature. In particular, frictional costs are introduced to explain loss aversion. The results are illustrated in a way that could perhaps be presented to users of financial calculators to elicit their preferences and assist in making more coherent decisions