Ambiguity Aversion

Ambiguity Aversion
In decision theory and economics, ambiguity aversion (also known as uncertainty aversion) describes an attitude of preference for known risks over unknown risks. People would rather choose an option with fewer unknown elements than with many unknown elements. It is demonstrated in the Ellsberg paradox (i.e. that people prefer to bet on an urn with 50 red and 50 blue balls, than in one with 100 total balls but where the number of blue or red balls is unknown). There are a number of choices involving uncertainty and normally they can be classified in two categories: risky and ambiguous events. Risky events have a certain probability for a given outcome. Ambiguous events have a much greater degree of uncertainty.

This refers to our behaviour as humans where we prefer to choose risk taking against uncertainty.
Because, if there is a risk, we can work out the probabilities of those risks, severity of those risks, mitigation plans in order to avoid risk from happening, possible outcomes if the risk occurs, and what are all the possible steps to take if it occurs.
So, it is also basically, the easier route that we take to make a decision. We mostly choose to take simple and easy decisions, rather than logical and smart.

Ambiguity Aversion examples
1. We know as soon as we take any good out of a showroom, its value drops as it becomes second sale. This is a risk as we know, but, how much value will drop is ambiguous. We need to collect a lot of data to find that out
2. When we are given a tough situation to choose an option, we prefer to look for prior examples, as what others have done in similar situation and would prefer to go by that
3. In TV shows, where the person who has won a certain amount is usually given a choice to choose to either exit from the show with the current price money, or continue to play and risk losing half of it or gain more in further rounds
4. What speculators do in stock markets is in my opinion making decisions in ambiguous situations and what investors do is risk taking based on their analysis of the business, and they may also use probability theories to assess the risk and accordingly shell out only a certain amount in a stock.
5. Insurance companies will always look for the word ‘risk’ when they underwrite any policy. They never even think of an ambiguous situation as they never cover those
6. Predicting the future price of a stock has an element of risk, but, we have data to analyse and research to bring down that risk substantially, but, predicting the future macro-economic scenario is ambiguous.

Overcoming Ambiguity Aversion
1. There is nothing in specific to do about this – other than trying to be rational and subjective in decision making based on facts and figures.
2. Check if the situation is risky or ambiguous – If risky, then you have a chance to work out something and come out successful. If ambiguous, try to avoid it, else if you have to make a decision, try to convert the ambiguous choice to at least a riskier choice, so that you have data points to make decisions.

My experience with Ambiguity Aversion
During 2008-09, I had invested in several stocks with proper analysis, or as much as I could, which covered the risk part better, but, I was counting on the future economic growth and GDP rates projected, which I did not realise was ambiguous. Hence, few bets I made in infrastructure sector went bad, and I had to exit them at a loss.


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Filed under Behavioural Finance

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