Behavioural Finance Ambiguity Aversion Bias Bias Description Bias

Behavioural Finance Ambiguity Aversion Bias

Bias Description �Bias Name: Ambiguity Aversion �Bias Type: Cognitive �General Description: Humans do not like to gamble with an uncertain probability distribution. Risk = gamble with precise probability distribution. Uncertainty = distribution of possible outcomes resulting from a gamble that cannot be known. 2

Bias Description Which would you choose? 1. 2. Betting on a the outcome of an organized football game Betting on a slot machine that displays either “ 1” or “ 2” and you must match your pick? 3

Technical Description L. J. Savage, The Foundations of Statistics (1954): Posited the “Subjective Expected Utility Theory” (SEUT) as counter to Expected Utility Theory in Economics. “Under certain conditions, an individual’s expectation of utility is weighted by that individual’s subjective probability assessment” 4

Practical Application �Study by C. Heath and Amos Tversky found that ambiguity aversion factors into a person’s probability evaluation depending on the investor’s subjective competence level. 5

Practical Application �People who feel knowledgeable prefer to stake claims on their own judgement rather than on equi-probable chance events. �People who do not feel knowledgeable prefer to wager on chance events. �This is known as “Competence Effect” 6

Implications for Investors �Uncertain investors likely to demand higher expected rate of return than they would demand if they felt certain about the risk/return trade off. Risk of the. Premium security. increases �Higher uncertainty = demand for higher exponentially equity premium as compensation for ambiguity in probability distribution. 7

Implications for Investors �Investors feel that domestic stock indexes are more familiar – less ambiguous – than foreign stocks which leads to underdiversified portfolios. �Investors are often weighted too heavily in stock of company they work for… because it is familiar. �Competency Effect lead to increased trading volume in portfolios which often results in lowered returns. 8

Research Review “Investor Competence, Trading Frequency and Home Bias” Graham, Harvey and Huang 1. 2. 3. Subjectively “Competent” Investors: Act on their own judgments Diversify geographically and across asset classes Trade more often 9

Conclusions �With Ambiguity Aversion investors can hold portfolios with a disproportionate amount of securities that they know and understand (employer’s stock, domestic stock etc. ) �Equity premium requested leads them to sometimes “go for it” when a hot tip is offered with an extraordinary potential return. 10

Conclusions �With Competency Effect investors must avoid under diversification by “loading up” on securities they know… ex: real estate, mining, banking etc… �“Trading is bad for your Wealth!” 11