Asset prices are all about expectations, but making that statement means more than just observing and acting on the mean of the distribution. It also included analysis of volatility and the tails of the distribution. You must look at all pay-offs of the distribution. The investor who only looks at the first moment of the distribution, the mean, is like the blind man who touching only one part of an elephant. He is missing key information.
A broader approach based on the distribution of price views places more emphasis on ambiguity in forecasts and expectations. The dispersion of opinions and the uncertainty in conviction should have an important impact on financial price behavior since prices are based on forward expectations. As important, ambiguity will have an impact on the investor behavior because of risk aversion and what has been called ambiguity avoidance.
A focus on the difference between risky and ambiguous situations is increasing relevant for understanding financial markets. Risk is associated with situations when the odds are known. For example, betting on a roll of the dice is risky, but odds can be calculated. An ambiguous situation is when the odds are not known or well-defined. Under situations of ambiguity, investors will often choose the risky option which seems more certain. There is a difference in betting on situations where the probabilities are know versus those situations when the odds are unclear. If ambiguity increases, investors will always choose options that are easier to measure.
This is why measures of ambiguity or uncertainty are so relevant. If investors always prefer certain environments even if risky over ambiguous situations, we should expect to see portfolios adjust to safe assets when uncertainty increases. A good review of the issues concerning ambiguity avoidance has been written by Mark Machina in the December issue of the American Economic Review.
The ability to assess or appreciate ambiguity is critical for systematic traders because it provides insight on why there are market frictions and why prices may not adjust immediately to new information.
A broader approach based on the distribution of price views places more emphasis on ambiguity in forecasts and expectations. The dispersion of opinions and the uncertainty in conviction should have an important impact on financial price behavior since prices are based on forward expectations. As important, ambiguity will have an impact on the investor behavior because of risk aversion and what has been called ambiguity avoidance.
A focus on the difference between risky and ambiguous situations is increasing relevant for understanding financial markets. Risk is associated with situations when the odds are known. For example, betting on a roll of the dice is risky, but odds can be calculated. An ambiguous situation is when the odds are not known or well-defined. Under situations of ambiguity, investors will often choose the risky option which seems more certain. There is a difference in betting on situations where the probabilities are know versus those situations when the odds are unclear. If ambiguity increases, investors will always choose options that are easier to measure.
This is why measures of ambiguity or uncertainty are so relevant. If investors always prefer certain environments even if risky over ambiguous situations, we should expect to see portfolios adjust to safe assets when uncertainty increases. A good review of the issues concerning ambiguity avoidance has been written by Mark Machina in the December issue of the American Economic Review.
The ability to assess or appreciate ambiguity is critical for systematic traders because it provides insight on why there are market frictions and why prices may not adjust immediately to new information.
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