Topic: Ambiguity Aversion By - Group 5 Monysh Bandeally (07) Warada Bhagwat (08) Sayali Bhanage (10) Saona Bhattacharya (12) Shobhit Mishra (36)

Introduction
In decision theory and economics, ambiguity aversion (also known as uncertainty aversion) describes a preference for known risks over unknown risks. An ambiguity averse individual would rather choose an alternative where the probability distribution of the outcomes is known over one where the probabilities are unknown. This behavior was first introduced through the Ellsberg paradox (people prefer to bet on the outcome of an urn with 50 red and 50 blue balls to on one with 100 total balls but for which the number of blue or red balls is unknown).
There are a number of choices involving uncertainty and normally they can be classified in two categories: risky and ambiguous events. Risky events have a certain probability distribution over outcome while ambiguous events have some uncertainty over said probability distribution. The reaction is behavioral and still being formalized. Ambiguity aversion can be used to explain incomplete contracts, volatility in stock markets, and selective abstention in elections (Ghirardato & Marinacci, 2001)
The distinction between ambiguity aversion and risk aversion is important but subtle. Risk aversion comes from a situation where a probability can be assigned to each possible outcome of a situation and it is defined by the preference between a risky alternative and its expected value. Ambiguity aversion applies to a situation when the probabilities of outcomes are unknown (Epstein 1999) and it is defined through the preference between risky and ambiguous alternatives, after controlling for preferences over risk.
Using the traditional two-urn Ellsberg choice, urn A contains 50 red balls and 50 blue balls while urn B contains 100 total balls (either red or blue) but the number of each is unknown. An individual that prefers a certain payoff strictly smaller than $10 over a bet that pays $20 if the color of a ball drawn from urn a is guessed correctly and $0 otherwise is said to be risk averse but nothing can be said about her preferences over ambiguity. On the other hand, an individual that strictly prefers that same bet if the ball is drawn from urn A over the case where the ball is drawn from urn B is said to be ambiguity averse but not necessarily risk averse.
A real world consequence of increased ambiguity aversion is the increased demand for insurance because the general public are averse to the unknown events that will affect their lives and property (Alary, Treich, and Gollier 2010).

Implications of Ellsberg-paradox
1. Human Beings stick With a Known Situation, Even if It’s Bad for You
The Ellsberg Paradox suggests that Human beings are so risk averse that we choose to stick with bad situations rather than face uncertainty. Uncertainty is scary.
But is fear of the unknown going to keep humans stuck in a situation they know is making you miserable?
2. Humans Can’t Embrace Change
When change is outside of our control, the psychological barriers are even worse.
Part of the reason volunteers don’t pick the second urn in the Ellsberg Paradox is that the ratio of white to black marbles is outside our control. Picking a black marble out of either urn is still up to chance, but at least the ratio can’t change on you like in the second urn.
Embracing change is one of the key strategies to live an agile lifestyle. Because the world around us is changing so quickly, only the agile among us will thrive. But being agile means getting comfortable with the vast amount of stuff that’s outside our control.
3. You Aim Low and Settle for Mediocre Results
The second urn in the Ellsberg Paradox could contain 100 black marbles and we might always win the $100. But we will never know since we always stick with the 50/50 urn.
That’s how many of us treat our lives. We stay in mindless corporate jobs for the “security” and climb the ladders others set out for us, never thinking what heights we could reach if we were just a bit more comfortable with uncertainty.
4. You Let Other People Talk You Out of Everything
While you’re struggling with all this ambiguity, the other people in our life definitely won’t get it. From the outside looking in, they’ll never understanding why you want to give up your high-prestige Fortune 500 job for the chaotic uncertainty of being an entrepreneur or an artist.
Because they don’t know the toll it’s taking on you mentally, physically, or emotionally, they compare the things they can measure (salary, benefits, etc.) and figure you’re crazy for going with the unknown.

Where do we find this bias?
When market participants face imprecise information their decisions are often shaped by their ambiguity attitude. An ambiguity averse player would prefer a risky prospect with 50% success probability to a prospect with an unknown probability of success. 1. Stock Market
Since stocks involve both risk and ambiguity and since investors are ambiguity averse their propensity to invest in stocks is lower than that predicted by neoclassical models because of volatility in the market.
An increase in ambiguity has a negative and statistically significant impact on net flows and net exchanges, supporting our hypothesis that increases in ambiguity lead to a reduction in equity market participation. Moreover, while there is a clear link between ambiguity and net fund flows and exchanges, the impact of risk is negative but not statistically significant.

2. Equity Market Home bias
Bond or Options with individual companies experiment showed that investors do show higher rate of ambiguity aversion when it comes to unfamiliar assets and the investors are more familiar with home country assets.
The equity market home bias occurs when the investors over-invest in their home country assets. The equity market home bias is a paradox because the investors are not hedging their risk optimally.

3. Non-Equity Fund Flows
In this section we examine the relationship between changes in ambiguity and flows in funds that invest in non-equity asset classes, namely hybrid, government and corporate fixed income and money market. It is reasonable to expect that in response to an increase in ambiguity in the stock market, investors will transfer funds into less ambiguous, non-equity investments.
As ambiguity increases investors withdraw capital from equity funds and reinvest at least partially in money market funds.
Since our ambiguity measure is based on the stock market’s forecast of long-term growth, one possible explanation for this finding is that investors are seeking safer assets with higher liquidity when faced with higher ambiguity in expected stock returns.

4. Different Equity Styles
In this we will see the relationship between ambiguity and fund flows for the five investment objective categories separately, namely ‘aggressive growth’, ‘growth’, ‘sector’, ‘growth and income’ and ‘income equity’.
For the ‘aggressive growth’ and ‘growth’ categories, the coefficient on the change in ambiguity is negative and highly statistically significant. For the ‘growth and income’ and ‘income equity’ categories, the coefficient is negative but not significant, while for the ‘sector’ category, the coefficient is insignificantly positive.

5. Capital budgeting
Within business specifically, the outcomes of prospective capital investments are rarely known with certainty, and outcome ambiguity is the rule rather than the exception. Further, uncertainty and ambiguity have been shown to negatively influence managers' resource allocation decisions.
When rendering capital investment decisions, managers often are faced with multiple options from which to choose on behalf of the firm. The uncertainty and ambiguity inherent in capital investment decisions increase choice complexity and task difficulty which, in turn, influence deliberative processes and ultimate choice.
Individual characteristics, such as tolerance for ambiguity and dispositional affect, have been shown to influence decision making in an environment of uncertainty and ambiguity. Specifically, tolerance of ambiguity (TOA) has been shown to influence decision making across a number of business contexts including but not limited to capital. In business contexts set in environments of uncertainty and ambiguity, dispositional affect also has been shown to influence audit judgment, ethical decision making and investment decisions.

Methods to avoid * Introduction
From the research paper “IS LUCK ON MY SIDE? OPTIMISM, PESSIMISM, AND AMBIGUITY AVERSION” by BRIONY PULFORD (2009).UNIVERSITY OF LEICESTER, UK
How do people make decisions when they face uncertainty? Would their choice change if they face even more (less) uncertainty? Approaches to decision-making in uncertainty range from the conventional expected utility theory (EU) axiomatized by von Neumann and Morgenstern (1944) and Savage’s (1954) subjective utility to extremely pessimistic (optimistic) choices of prospects with the worst (best) outcomes, Hurwicz (1951) weighted average criterion, prospect theory by Kahneman and Tversky (1989) and its modifications, Choquet Expected Utility by Schmeidler (1989), Maxmin expected utility by Gilboa and Schmeidler (1989), Alpha model by Ghirardato et al. (2004), just to name some most frequently quoted; see Hey et al. (2010) for a review of these theories. In this paper we focus on situations when the decision-making cannot be described by the EU approach or its modifications. Examples would include ambiguity embedded in agents’ preferences (Easley and O’Hara, 2009), lack of information in the flight to quality episodes (Caballero and Krishnamurthy, 2008), political ambiguity (Vinogradov, 2012), etc. We study subjects’ choice between a risky prospect (with a known probability of success) and an ambiguous prospect (for which the probability of success is unknown) and changes in this choice induced by the news about the behaviour and observations of others.
Ambiguity is often associated with "vague probabilities" (Trautmann et al., 2008), "imprecisely known" probabilities (Kühberger and Perner, 2003), or a "range of probabilities" (Keren and Gerritsen, 1999), etc. In the simplest case this range of probabilities is the whole simplex. Can a decision-maker (DM) narrow the range of possible probabilities down to a smaller set of priors? We alter the famous Ellsberg (1961) two-urn task by varying the signals about the ambiguous prospect’s probability of success. The generated changes in the subjects’ choice enable us to characterize the length of the interval of priors (and therefore the perceived precision of the signal) and to compare it across subject groups and types of signals. In particular, we obtain that news that promise a better probability of success are perceived as less precise than those that communicate a lower probability of success. Epstein and Schneider (2008) derive a similar effect theoretically by assuming that the DM has a unique prior for the parameter to be learnt but the signal is related to the actual value of the parameter through a family of likelihoods, which in effect generates ambiguity about the parameter itself.

* PERCEPTIONS OF THE SITUATION
The degree of trust in the experimenter is strongly influenced by participant’s optimism. Rigging – not influenced by optimism in conditions 1 or 2. Pessimism – no discernible pattern of influence on ratings. * DISCUSSIONt
Trust & rigging scores indicate that when the random-selection information was missing (in Condition 2) the situation was construed as potentially more competitive, as Kühberger and Perner (2003) proposed. It is the presence of optimism, not the absence of pessimism that reduces ambiguity aversion. People who do not have highly optimistic personalities tended to be extremely ambiguity averse on this task, even when no competitor is in sight. The hostile nature or competitive other theories do not seem capable of explaining this. * SPECULATION
Highly optimistic people appear to feel that luck may be on their side, even when a potential competitor is involved, or perhaps feel optimistic that the experimenter is not a competitor and is trustworthy. * CONCLUSION
When ambiguity is clear, and trust issues are removed, people’s optimistic outlook influences their degree of ambiguity aversion, and thus their decisions. Explanations for ambiguity aversion range from the dislike of missing information (Frisch & Baron, 1988), especially if an opponent is perceived to have that information, and fear of negative evaluation by other people if the ambiguous thing turns out to have been a bad choice (Trautmann, Vieider, & Wakker, 2008). Finally, realize that every decision you make cannot be generalized, and that each one needs to be taken in its own individual context.