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Two-Moment Decision Model

The two-moment decision model is an economic theory that assumes investors make decisions based on two key factors: the expected return (mean) and the risk (variance) of their investments. The model simplifies the decision-making process by focusing on these two moments of the return distribution, assuming that investors are rational and prefer higher returns and lower risk. This model forms the basis of modern portfolio theory, which emphasizes balancing risk and return.

Example

An investor choosing between two portfolios compares their expected returns and standard deviations (risk). The portfolio with a higher expected return and lower risk would be preferred under the two-moment decision model.

Key points

• A decision-making model based on the mean (expected return) and variance (risk) of an investment.

• Assumes rational investors prefer higher returns and lower risk.

• Forms the foundation of modern portfolio theory and risk-return trade-off analysis.

Quick Answers to Curious Questions

It helps investors assess the trade-off between expected returns and risk, forming the basis of constructing efficient portfolios.

By focusing on just two factors—mean and variance—it simplifies the evaluation of potential investments, assuming rational behavior and risk aversion.

The model assumes that returns are normally distributed, which may not hold true in all markets, and it may overlook other factors like liquidity and transaction costs.