Friday, April 15, 2011

Risk vs Uncertainty

Humans don't like ambiguity. This is demonstrated in the experiment Hersh Shefrin discusses where subjects are offered either a guaranteed $1000, or a 50/50 chance at $2000. Consistently, fewer than 50% of respondents prefer the gamble for $2000, even though the expected values (i.e. the average value of the result if it were conducted many times) of both offers are the same.

What if the 50/50 odds in the above experiment were instead unknown? This adds even further uncertainty to the situation, and results in even fewer people willing to gamble on the $2000.

Shefrin calls this phenomenon "aversion to ambiguity", and on Wall Street it results in downward pressure on the prices of securities with uncertain outlooks. In order to avoid uncertainty/ambiguity, humans will stay away, even if the odds are favourable (i.e. downside risk is low, upside potential is high).

In his book, Shefrin argues that this ambiguity aversion is the reason for government intervention, even when it is not needed. What would have happened had the government not bailed out the banks? Nobody really knows, but the fact that the outlook was uncertain made the government want to intervene, even at a high cost, in order to avoid the uncertain situation.

As Mohnish Pabrai notes in his book, risk is not the same as uncertainty. Uncertainty can drive down the prices of assets/securities, even if downside risk is low. By capitalizing on situations where uncertainty is high, but risk is low, the investor can put himself in a position to earn above-average returns.


Paul said...


Have you ever read Pabrai's other book Mosaic: Perspectives on Investing?

Saj Karsan said...

I haven't. Do you recommend it?

Paul said...


I wish I had something to say about it, but I've only started really looking at it recently. I don't have it yet, and was hoping to get your opinion! :)

I found it while looking for Dhando Investor on amazon. It's pretty pricey, though.

I posted about it on a forum I frequent, and the guy who replied said the price isn't justified. He also supplied this link. The book is basically made up of a bunch of things already freely published.

Patrick said...

The choice of 100% chance of $1000 over a 50% chance of $2000 can be a perfectly rational one. It depends on what you're trying to achieve. If you're stretched at the end of the month and need a few bucks to buy your wife a birthday gift, why risk a 50% chance of being left broke?

There's a lot more to financial decision making than comparing expected values.