Ambiguity in Individual Choice and Market Environments: On the Importance of Comparative Ignorance (original) (raw)

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Ambiguity and asset prices: an experimental perspective

2006

Most of the economics and finance literature assumes that individual agents obey the Savage axioms; that is, they maximize expected utility according to subjective priors. However, Knight, Ellsberg and others argue that individual agents distinguish between risk (known probabilities) and uncertainty, or ambiguity (unknown probabilities), and that individual agents may display aversion to ambiguity, just as they display aversion to risk. This paper studies the impact of ambiguity aversion on equilibrium asset prices and portfolio holdings in competitive financial markets. It argues that attitude toward ambiguity is heterogeneous in the population, just as attitude toward risk is heterogeneous in the population, but that heterogeneity in attitude toward ambiguity has different implications than heterogeneity in attitude toward risk: agents who are sufficiently ambiguity averse find open sets of prices for which they refuse to hold an ambiguous portfolio. This leads to a wider range of state price densities and to potential reversals of ranking of state price densities. Experiments confirm the theoretical predictions.

Does ambiguity aversion survive in experimental asset markets?

Journal of Economic Behavior & Organization, 2014

Although a number of theoretical studies explain empirical puzzles in finance with ambiguity aversion, it is not a given that individual ambiguity attitudes survive in markets. In fact, despite ample evidence of ambiguity aversion in individual decision making, most studies find no or only limited ambiguity aversion in experimental financial markets, even when they exclude arbitrage. We argue that ambiguity effects in markets depend on market feedback and on a sufficiently strong bias toward ambiguity among the participants. Accordingly, we find significant ambiguity effects in low-feedback call markets for assets that provoke high ambiguity aversion, but no ambiguity effects in high-feedback double auctions.

Ambiguity in asset markets: theory and experiment

Review of Financial …, 2010

This paper studies the impact of ambiguity and ambiguity aversion on equilibrium asset prices and portfolio holdings in competitive financial markets. It argues that attitudes toward ambiguity are heterogeneous across the population, just as attitudes toward risk are heterogeneous across the population, but that heterogeneity of attitudes toward ambiguity has different implications than heterogeneity of attitudes toward risk. In particular, when some state probabilities are not known, agents who are sufficiently ambiguity averse find open sets of prices for which they refuse to hold an ambiguous portfolio. This suggests a different cross-section of portfolio choices, a wider range of state price/probability ratios and different rankings of state price/probability ratios than would be predicted if state probabilities were known. Experiments confirm all of these suggestions. Our findings contradict the claim that investors who have cognitive biases do not affect prices because they are infra-marginal: ambiguity averse investors have an indirect effect on prices because they change the per-capita amount of risk that is to be shared among the marginal investors. Our experimental data also suggest a positive correlation between risk aversion and ambiguity aversion that might explain the "value effect" in historical data.

Ambiguity aversion: experimental modeling, evidence, and implications for pricing∗

2013

This paper provides a systematic analysis of individual attitudes towards ambiguity, based on laboratory experiments. The design of the analysis captures different degrees of ambiguity in various settings, and it allows to disentangle attitudes towards risk and attitudes towards ambiguity. In addition to individual attitudes, the experiments also elicit expectations about other participants’ attitudes, allowing us to relate own behavior to expectations about others. New measures are introduced for both, the degree of ambiguity in a situation and ambiguity aversion. Ambiguity is embedded in standard utility theory and a parameter of ambiguity aversion is estimated and contrasted to the parameter of risk aversion. The analysis provides a test of theoretical models of ambiguity aversion. The main findings are that ambiguity aversion on average is much more pronounced than human aversion against risk and that it is very different across individuals. Moreover, while most theoretical work...

Ambiguity attitudes and economic behavior

2013

We measure ambiguity attitudes for a representative sample of U.S. households using a customdesigned module in the American Life Panel. Ambiguity attitudes vary substantially across people: half are ambiguity averse, 12% ambiguity neutral, and 37% ambiguity seeking. Further, ambiguity attitudes depend on the likelihood of the ambiguous event: people tend to overweight low-likelihood ambiguous events and underweight high-likelihood events, a phenomenon called ambiguity-likelihood insensitivity. Consistent with theoretical predictions, higher ambiguity aversion is associated with less equity market participation, lower portfolio allocations to equities, and more retirement planning. High ambiguity-likelihood insensitivity is associated with a higher probability of being insured. JEL Codes: G11, D81, D14, C83

The impact of ambiguity on prices and allocations in competitive financial markets

2003

This paper studies the impact of ambiguity and ambiguity aversion on equilibrium asset prices and portfolio holdings in competitive financial markets. It argues that attitudes toward ambiguity are heterogeneous across the population, just as attitudes toward risk are heterogeneous across the population, but that heterogeneity of attitudes toward ambiguity has different implications than heterogeneity of attitudes toward risk. In particular, when some state probabilities are not known, agents who are sufficiently ambiguity averse find open sets of prices for which they refuse to hold an ambiguous portfolio. This suggests a different cross-section of portfolio choices, a wider range of state price/probability ratios and different rankings of state price/probability ratios than would be predicted if state probabilities were known. Experiments confirm all of these suggestions. Our findings contradict the claim that investors who have cognitive biases do not affect prices because they are infra-marginal: ambiguity averse investors have an indirect effect on prices because they change the per-capita amount of risk that is to be shared among the marginal investors. Our experimental data also suggest a positive correlation between risk aversion and ambiguity aversion that might explain the "value effect" in historical data.

Ambiguity aversion and wealth effects

Journal of Economic Theory, 2022

We study how changes in wealth affect ambiguity attitudes. We define a decision maker as decreasing (resp., increasing) absolute ambiguity averse if he becomes less (resp., more) ambiguity averse as he becomes richer. Our definition is behavioral. We provide different characterizations of these attitudes for a large class of preferences: monotone and continuous preferences which satisfy risk independence. We then specialize our results for different subclasses of preferences. Inter alia, our characterizations provide alternative ways to test experimentally the validity of some of the models of choice under uncertainty.

Cognitive Biases, Ambiguity Aversion and Asset Pricing in Financial Markets

SSRN Electronic Journal, 2000

We test to what extent financial markets trigger comparative ignorance (Fox and Tversky (1995)) when interpreting news, and hence, to what extent such markets instill ambiguity aversion in participants who do not really know how to correctly update. Our experiments build on variations of the Monty Hall problem, which, when tested on individuals separately, are well known to generate obstinacy: subjects often refuse to acknowledge that they are wrong. Under comparative ignorance, however, subjects who are not able to correctly solve Month-Hall-like problems should become ambiguity averse. In a financial markets context, we posit that such feeling of comparative ignorance emerges when traders, who do not have the correct solution, face prices that contradict their beliefs. Previous experiments with financial markets have shown that ambiguity aversion makes subjects hold portfolios that are insensitive to prices; subjects instead prefer to hold balanced portfolios, and hence, are not exposed to ambiguity. And because subjects are price-insensitive, they do not contribute to price setting. This led us to hypothesize that, when faced with Monty-Hall-like problems, (i) there would be subjects whose portfolio decisions are insensitive to prices, (ii) price quality would be inversely related to the proportion of price-insensitive subjects, (iii) price-insensitive subjects tend to choose more balanced portfolios (correcting for mispricing), and (iv) price-insensitive subjects trade less. Our experiments confirm these hypotheses. We do discover, however, the presence of a minority of price-sensitive subjects who simply tend to buy more as prices increase. We interpret the behavior of such subjects as herding, a hitherto unsuspected reaction to comparative ignorance. Altogether, our experiments suggest that cognitive biases may be expressed differently in a financial markets setting than in traditional single-subject experiments.

Attitudes towards risk and ambiguity across gains and losses.

Theory and Decision

We use the multiple price list method and a recursive expected utility theory of smooth ambiguity to elicit attitudes to risky and ambiguous prospects. In particular we wish to investigate if there are differences in agent behaviour under uncertainty over gain amounts vis a vis uncertainty over loss amounts. On an aggregate level, we find that (i) subjects are risk averse over gain and risk seeking over losses, displaying a "reflection effect" as documented in Amos Tversky and Daniel Kahneman (1992) and (ii) they are mildly ambiguity averse over gains and are mildly ambiguity seeking over losses. Further analysis shows that on an individual level, and with respect to both risky and ambiguous prospects, there is limited incidence of reflection effects where subjects are risk/ambiguity averse (seeking) in gains and seeking (averse) in losses, though this incidence is higher for ambiguous prospects. A very high proportion of such cases of reflection exhibit risk (ambiguity) aversion in gains and risk (ambiguity) seeking in losses, with the reverse effect being significantly present in the case of risk but almost absent in case of ambiguity. Finally, our results suggest that reflection across gains and losses is not an individual trait but depends upon whether the form of uncertainty is precise or ambiguous since we rarely find an individual who exhibits reflection in both risky and ambiguous prospects.

Prices and allocations in asset markets with heterogeneous attitudes towards ambiguity

Review of Financial …, 2007

This paper studies the impact of ambiguity aversion on equilibrium asset prices and portfolio holdings in competitive financial markets. It argues that attitude toward ambiguity is heterogeneous in the population, just as attitude toward risk is heterogeneous in the population, but that heterogeneity in attitude toward ambiguity has different implications than heterogeneity in attitude toward risk. Specifically, agents who are sufficiently ambiguity averse find open sets of prices for which they refuse to hold an ambiguous portfolio. This leads to a wider range of state price densities and to potential reversals of ranking of state price-probability ratios relative to aggregate wealth. In addition, the distribution of holdings will have a new mode, with highly ambiguity averse agents holding securities with ambiguous payoffs in equal proportions. Under pure risk, the distribution of holdings has a single mode equal to the market portfolio weight. Experiments confirm the theoretical predictions. While price patterns often look little different from those under pure risk, portfolio choices display strong effects from the presence of ambiguity. The experiments also suggest a positive correlation between risk aversion and ambiguity aversion, which may explain the "value effect" in field data. † We are grateful for comments to seminar audiences at CIRANO, U.C. Irvine, Kobe University, Collegio