Most people are ambiguity averse, meaning that they prefer to make decisions when they face known probabilities (risk), rather than unknown probabilities (ambiguity). In the real world, investment decisions nearly always involve ambiguity, as the probability distribution of future outcomes is often not well known.
A new paper by experts at Wharton and elsewhere examined a range of investor attitudes toward risk and uncertainty using a survey of some 300 investors and 230 non-investors in the Netherlands. Their 2018 survey assessed both risk and ambiguity aversion for four different types of investments: a familiar company stock, a local stock index, a foreign stock index, and the cryptocurrency Bitcoin. All respondents who completed the survey had a chance to win a prize based on their choices, and a total of €2,758 in real incentives was paid out.
“Investors who perceive less ambiguity about a particular financial asset are more likely to invest in it,” stated the paper, titled “Ambiguity Attitudes for Real‑world Sources: Field Evidence from a Large Sample of Investors.”
The researchers found that about 58% of the respondents were ambiguity averse, while 30% were ambiguity seeking. Furthermore, ambiguity neutrality was rather uncommon (12%).
“Our findings show that people with less perceived ambiguity are also more likely to invest in assets that, for many, are the source of ambiguity,” said Olivia S. Mitchell, Wharton professor of business economics and public policy, and executive director of Wharton’s Pension Research Council. “We also show that ambiguity aversion does not significantly impact the probability of holding such assets.”
Mitchell co-authored the paper with Kanin Anantanasuwong, a lecturer at Thailand’s Mahidol University, Roy Kouwenberg, a professor at Mahidol University, and Kim Peijnenburg, professor of household finance at Tilburg University in the Netherlands.
How Ambiguity Aversion Plays Out
As the evidence shows that a majority of people are ambiguity averse, this implies that they prefer to make decisions when they face known probabilities, rather than unknown probabilities, the authors point out. “People’s choices not only reveal ambiguity aversion, common for likely gains, but also ambiguity seeking for unlikely gains and for losses,” they added.
One of the key contributions of the paper is to measure ambiguity attitudes for relevant real-world sources in a relatively large set of real-world investors. This is because households must often make financial decisions about saving, investment, and insurance, where the probability distribution of future outcomes is not precisely known.
The authors also discuss how their measures of ambiguity attitudes relate to investors’ actual investment choices. They document that investors who perceive less ambiguity about a particular financial asset are more likely to invest in it. Further, investors with greater ambiguity aversion are less likely to invest in cryptocurrency. Ambiguity aversion is also highly correlated across different assets, while people’s perceived ambiguity differs more across assets.
While ambiguity aversion is common, it is not universal when it comes to real-world assets, the authors report. For instance, people’s ambiguity aversion for a familiar stock was 34% lower compared to their response to uncertainty in returns on the MSCI World Index. This implies that investors, in aggregate, do display preferences for a familiar stock over a global stock market index.
Another interesting result was that ambiguity aversion is lower for more financially literate and better-educated investors.
“When people face less ambiguity about an asset’s investment returns, they are more likely to invest in the asset.”— Olivia S. Mitchell
Remedies to Address Ambiguity
The authors conclude, based on their study, that ambiguity aversion is a source-independent trait, akin to a preference. Moreover, ambiguity aversion often leads to sub-optimal decision-making, leading people to avoid investing in stocks altogether.
One way to get around that challenge is to provide decision-makers with additional information to clarify the distribution of potential outcomes when they invest in an asset, the authors suggest. That is because the impact of ambiguity aversion on decisions is reduced when people are more aware of what the results of their actions could be.
“Providing more information and context for investment products could encourage participation in equity markets, as it can reduce perceived ambiguity,” Mitchell said. “Perceived ambiguity represents the cognitive component of ambiguity attitudes, the feeling of having imprecise or insufficient information.”
Stimulating equity market participation has long been an endeavor for regulators, such as disclosure requirements stipulated by the Securities and Exchange Commission. “The SEC does play an important role in reducing ambiguity, with its disclosure requirements for listed companies and mutual funds,” Mitchell said.
“Yet providing more detail might be insufficient for people unfamiliar with financial markets in the first place,” Mitchell continued. “To help them, it might be better to provide more education about the benefits of regular saving and investing, the power of compounding returns over time, and ways to understand risk.”
The U.S. may want to look at Sweden for inspiration on expanding financial literacy, Mitchell suggested. She noted that the U.S. has “the deepest public and private capital markets in the world,” and that they have been “very successful in financing innovation in technology and healthcare, while also providing excellent returns for retail investors and pension funds.” Equity market participation is also relatively high in the United States compared to most European countries, she added.
“Nevertheless, in Europe, Sweden stands out with its vibrant capital market and high retail investor participation,” she continued. “That nation has managed to nurture high retail participation through financial literacy initiatives, such as a national network for financial education, and a ‘Young Shareholders’ club for high school students.”
