Join our community of smart investors

On ambiguity aversion

Investors dislike unknown probabilities. Sometimes, they are right to do so
On ambiguity aversion

Many of you are sticking with equity income funds despite their recent travails. In some cases, this reflects a widespread attitude which has many implications for financial markets. I’m thinking of ambiguity or uncertainty aversion – our tendency to prefer familiar probabilities to unfamiliar ones.

This was first pointed out in 1961 by Daniel Ellsberg, who would go on to achieve fame for leaking the Pentagon Papers during the Vietnam war. He gave colleagues a choice of two bets. In one, they could bet on drawing a red or black ball from an urn containing 100 balls, 50 of each colour. In the other bet, the urn had 100 red and black balls in unknown proportions. He found that his colleagues preferred to bet on the known odds than the unknown ones. Many experiments since then have corroborated this.

Sticking with income stocks and funds is an example of this uncertainty aversion. Dividends are known while growth is uncertain. And many income fund managers, such as Neil Woodford, have long track records which gives them a familiarity to investors. Uncertainty-averse investors thus prefer income stocks and funds to growth stocks.

To continue reading...
Join our Community of Smart Investors
  • Independent full-length company analysis
  • Actionable investment ideas and recommendations
  • Expert investment tools and data
  • Stock screens from Algy Hall
Have an account? Sign in