Ambiguity aversion refers to the bias when people tend to lean towards known outcomes over unknown ones. They want to avoid uncertainty and choose what they are confident of. It is applicable when a choice has to be made between risky or ambiguous alternatives.
In the context of investments and investors, ambiguity aversion bias leads investors to hesitate in situations that are ambiguous. When there is a change in the usual rate of interest (for example) on a financial product, decisions taken by the investor would depend on his subjective competence level. He will put his stakes based on his knowledge and understanding of the whole scenario. If he’s skillful enough to assess the outcomes, he would probably place his stakes on the outcomes with higher risks.
Competence effect and investors
However, if he isn’t skilful or knowledgeable about the above development, he would not factor that in to his decision. This is called competence effect, when decisions are made based on one’s competence or knowledge about the situation.
These are some of the effects of ambiguity aversion bias or the competence effect in an investor:
- The most obvious effect of ambiguity aversion bias can be noted when it comes to evaluating returns of a financial product. An unsure or inexperienced investor will ask for higher expected returns than when he is sure of the trade-off.
- Investors hesitate to diversify and explore products that they are not familiar with, thus limiting their diversification. For example, an Indian investor might not venture into foreign stock products for fear of going wrong with calculations or assessment.
- They look for investment options that are geographically closer and thus, less ambiguous and less risky. So the chances of diversifying their portfolio get limited. This also means profits or returns that come with higher risk investments are not explored.
- The familiarity factor also tends to attract bad investments because investors want to make safe investment decisions. For example, an employee may invest in his company’s stock, which may actually be under-performing, just because he feels it would be a safe investment due to the familiarity factor.
Tackling ambiguity aversion bias
- To avoid ignoring potentially profitable outcomes, investors should be educated on various asset classes and ways to evaluate them under different scenarios. They can broaden their knowledge spectrum about financial products and take informed decisions about what and how to distribute their investments.
- Investors should spend time with data and research to understand each products and developments associated with each. Thus they can predict payoffs better, in turn paving the way for better returns.
- Investors should also be made aware of potential mistakes, mainly those that others similar to them have made.
Increasing competence of an investor is the key to tackling ambiguity aversion bias. Investment decisions are invariably made based on one’s subjective knowledge and resources available at hand. A well-balanced and diversified portfolio of investments is possible only when sound investment decisions are made at the right time, factoring in the right probabilities.