Cognitive Bias: Ambiguity aversion

As an investor, you have three investment options for the next semester:

  1. You get €500.000 for sure
  2. You invest in a stock with a 50% of chance of earning €1M or nothing
  3. You invest in an industrial project on which you have little information except that you can earn €1M, if it is successful or nothing otherwise.

What do you choose?

Most investors choose the safe option 1, and then the option 2. They prefer to avoid the option 3.

Why? Because most investors try as much as possible to avoid uncertainty when making a financial investment.

Let’s explore further how the brain works to understand the mechanisms of this ambiguity bias.

Option 1: Safe option

The first option is easy to understand. We know that we get €500.000 for sure. We can sleep comfortably.

Option 2: Risky option

The investment is risky. Based on traditional financial theories, a “rational” investor will compute the expected return of this investment (50% X €1M = €500.000) and, if he is risk-neutral, be indifferent between Option 1 and 2.

In practice, most investors are risk-averse and will choose the safe option 1.

This first bias is called risk aversion.

Option 3: Ambiguous option

Let’s move to the third option where the probability of success is unknown. For a “rational” and risk-neutral investor, the situation is equivalent to the first two options since the expected return is €500.000 in the three situations.

However, most investors will be much more comfortable with the option 2 than with the option 3, since the probability is known in Option 2 and not in Option 3. The level of uncertainty is thus higher in Option 3.

This second bias refers to our ambiguity aversion. This refers to the fact that we are very uncomfortable to make decisions when we ignore the probabilities of specific events.

References:

Prospect theory, for risk and ambiguity (2011), Wakker

Abdellaoui, M., Baillon, A., Placido, L., & Wakker, P. (2009). The rich domain of uncertainty. American Economic Review.

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