Ramesh goes to visit Suresh on a lazy Saturday afternoon. Suresh was diligently filling a form online. He peeps from behind and finds him applying for a bank FD. Ramesh exclaims: ‘A young man like you needs to invest in equities…not bank FDs’!
Suresh turns back and mentions with a smirk, ‘I know what return this FD will fetch me at the end of the year and will know about future rates from the bank in the future too! Even if my bank goes bust, I will get some money back as my FD is partially insured. Can you tell me with surety what returns I will make in equities this year and each year which follows?! ’
Ramesh just looks at the ceiling and then turns to Suresh and says, ‘It’s your money! Quickly fill up the form and let’s go out for a cup of coffee…’
This story is an illustration of the Ambiguity Aversion bias. Let us understand about the same in this edition of Money Wisdom.
Ambiguity means inexactness. People experiencing Ambiguity Aversion will prefer the ‘familiar’ in situations of uncertainty. Humans are generally uncomfortable with uncertainty and like to have a sense of fixedness. If we look at risk and uncertainty in conjunction, risk means that the outcomes and the chances of these outcomes are known but when there is uncertainty, the outcomes may be known but the chances of these happening are unknown. This bias is the testimony of the quote that a known devil is better than an unknown devil! Answer this simple question and it will all be clear: Would you bet on a coin toss or which team will win the IPL this year?!
From a financial perspective, here are a few observations of how ambiguity aversion bias can impact your financial lives:
1). We can make risk calculations but not for uncertainty. Risk calculations are only possible for ‘bounded systems with known set of outcomes’. Thus, we need to ignore forecasts and predictions (in % terms) for various outcomes of open ended and dynamically evolving systems like economies and the business ecosystem. The outcomes can be various unlike a coin toss.
2). Many investors sometimes demand a very high ‘compensation’ in investing due to this bias. It makes them invest in investments offering ‘certainty’ and makes them miss out the bumpy ride of wealth creation through equities over the long term. Conversely, people who feel they are competent enough take risks on ambiguous events perceived as certainty.
3). Experts also say that due to the impact of this bias, people find solace in investing in ‘familiar’ financial markets and the companies they work with or associated to.
How can we avoid being a victim of this bias?
1). Understand the difference (which might look subtle) between risk and uncertainty.
2). Avoid decision making basis comments from other people and specially media about probabilities of events and expected returns.
3). Learn to embrace ambiguity and take it in your stride.
To end with…let us get to know the ‘Unknown devil’! You then have the choice of befriending or avoiding it.
Let’s watch this video where Rolf Dobelli explains us about this bias and how not to be a victim of the same.
MUTUAL FUND INVESTMENTS ARE SUBJECT TO MARKET RISKS, READ ALL SCHEME RELATED DOCUMENTS CAREFULLY.