Wednesday, April 18, 2012

Is It Risky or Uncertain?

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.

1 comment:

juan said...

I agree with the general point of the comment. But in the experiment mentioned what makes people choose the sure $1,000 might not just be a dislike of ambiguity.
I'd choose the sure thing because the first $1,000 can be used to meet more pressing needs than the second $1,000, and is thus worth more.
That's also why I'd be willing to work longer for $1,000 than Bill Gates would - that money is worth more to me, because I don't already have as many multiples of it in the bank as he does.