There have been significant advances concerning our understanding of risk. Investors are growing more comfortable with the distinction between risk and uncertainty. Along with this distinction is the idea that investors also face ambiguity. There are formal definition of ambiguity, but a good working idea is to think about ambiguity as dealing with problems counting or measuring risk. There is a distribution of prices, yet we are not certain of the value or shape of the distribution. When the probabilities are not know or unclear, we are dealing with situations of ambiguity.
We will change our behavior when we face ambiguity. We have know this for a long time. The famous Ellsberg paradox suggests that people prefer decision situations with known probabilities to those where the probability are unknown. We have ambiguity aversion. The risk of not knowing the distribution we are facing makes us more risk adverse. This can be especially difficult issue when dealing with the tails of the distribution. Small changes in our beliefs in the shape of the distribution will have a large impact on the demand for investment products in the tails. Just think of what ambiguity will do with the pricing of out of the money options.
Recent experimental testing by Aurelien Baillon and Han Bleichrodt in the American Economic Journal: Microeconomics shows some interesting results that have application for how we should think investor behave. Unlikely events are overweighted and likely events are underweighted. The underweighting of those likely events is higher when it involves losses. The general pattern of tests suggest that there is ambiguity seeking for unlikely gains and likely losses and ambiguity aversion for likely gains and unlikely losses. This is consistent with work done on prospect theory, but gives us more experimental evidence.
Investors play for the long shot gains and want to avoid the long shot losses. Their behavior in the tails of the distribution will be driven by the amount of ambiguity faced.
We will change our behavior when we face ambiguity. We have know this for a long time. The famous Ellsberg paradox suggests that people prefer decision situations with known probabilities to those where the probability are unknown. We have ambiguity aversion. The risk of not knowing the distribution we are facing makes us more risk adverse. This can be especially difficult issue when dealing with the tails of the distribution. Small changes in our beliefs in the shape of the distribution will have a large impact on the demand for investment products in the tails. Just think of what ambiguity will do with the pricing of out of the money options.
Recent experimental testing by Aurelien Baillon and Han Bleichrodt in the American Economic Journal: Microeconomics shows some interesting results that have application for how we should think investor behave. Unlikely events are overweighted and likely events are underweighted. The underweighting of those likely events is higher when it involves losses. The general pattern of tests suggest that there is ambiguity seeking for unlikely gains and likely losses and ambiguity aversion for likely gains and unlikely losses. This is consistent with work done on prospect theory, but gives us more experimental evidence.
Investors play for the long shot gains and want to avoid the long shot losses. Their behavior in the tails of the distribution will be driven by the amount of ambiguity faced.
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