Mathematics

Jensen's Inequality

For a convex function, the expected value of the function is at least the function of the expected value.

E[f(X)] >= f(E[X]) for convex f, with the inequality reversed for concave f.

Why it explains so much. Convexity is valuable precisely because of this - a convex payoff benefits from uncertainty. It is the formal reason a long-option position gains from volatility.

The concave side explains risk aversion: with concave utility, the expected utility of a gamble is less than the utility of its expected value, so a certain amount is preferred to a fair bet.

It is also why the mean of a lognormal exceeds its median.

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