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.
Now, there is a big debate about whether such uncertainty aversion is rational or not – a debate I find largely pointless. What we do know, though, is that it is widespread. We see it in football managers preferring the old pro to the untried youngster; in bosses who reduce capital spending in the face of political uncertainty; in regulators who use the precautionary principle to err on the side of caution; and in stock-pickers who prefer to use traditional judgment-based methods rather than exploiting momentum or seasonal patterns.
There are two good reasons why people might be averse to bets on unknown odds.
One has been pointed out by Eric Rasmussen. If a 50:50 bet goes wrong, nobody will blame you and you shouldn’t feel bad. If, however, a bet on an unknown probability fails, it might in hindsight look like a bad bet which had little chance of success. That’ll make you feel bad, and will attract criticism if you were acting on someone else's behalf.
Secondly, where there is ambiguity there is the (by definition unknown) chance of disaster. Faced with this, it’s reasonable to want to minimise our potential losses. That can mean avoiding many ambiguous bets. This is the logic behind the precautionary principle, and it was Mr Ellsberg’s preferred explanation for his finding.
Whatever the reason for it, ambiguity aversion helps explain several otherwise curious facts about financial markets, such as:
- Why we prefer to invest in domestic equities. It’s because our home market feels familiar to us in a way that most overseas ones don’t: we can see the companies we invest in simply by walking down the street.
- Why the US has traditionally enjoyed an “exorbitant privilege” – lower borrowing costs than the country’s economic fundamentals would ordinarily justify. It’s because the US’s cultural hegemony means foreigners regard it as more familiar than most other nations: the US feels less foreign than, say, Japan or Germany.
- Why emerging markets have outperformed developed ones over the long run. One reason is that emerging markets carry more uncertainty than developed ones: about political stability, corporate governance and accounting rules and so on, and have less familiar companies. This has caused some investors to shy away from them, giving great returns to braver ones.
- Why there has been an equity premium puzzle – a tendency for shares to give higher returns than economic theory predicts. One reason is that equities carry not just risk – the known probability of a loss – but uncertainty: we can’t be sure that past volatility is a guide to future risks. Equities must therefore carry not just a risk premium, but also an uncertainty premium.
- Why takeovers often fail. In theory, companies wanting to collaborate with others could use joint ventures. These, however, expose them to ambiguity – the difficulty of writing full contracts and of enforcing them if something goes wrong. Takeovers remove such ambiguity by replacing a market transaction with simple management diktat. In paying to avoid such ambiguity, however, companies can end up paying too much.
You might think that ambiguity aversion should cause assets that carry lots of ambiguity to do well: because investors shy away from it, such assets must pay an ambiguity premium to attract and reward braver investors.
True, this is sometimes the case – in, for example, emerging markets. But it’s not always the case. High-ambiguity shares such as Aim stocks have badly underperformed low-ambiguity ones such as big defensives in the last 20 years: the last few months have only very slightly reversed this.
There might be a reason for this. Ambiguity doesn’t only mean an unknown chance of disaster. It also means a chance of great things. A smaller speculative stock gives you the chance of doubling your money in a few months whereas BP or AstraZeneca do not. Historically, investors have paid too much for this chance.
It is, however, not always unwise to chase ambiguity. If people didn’t pursue unknown probabilities we’d have very few entrepreneurs, musicians or artists. One of the best pieces of advice Nassim Nicholas Taleb gives in his book The Black Swan is that we should take as many opportunities as possible which give us unknown upside potential: going to parties, for example, give us the chance of meeting people who’ll become lifelong friends or inspire new ideas and ventures.
I suspect, however, that this advice applies much better to our personal lives than to our financial investments.
