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Ambiguity Aversion; One Factor in Market Corrections

August 1, 2020 | Commentary

  • Risk and uncertainty are two concepts that are often confused.  Risk is probabilistic and highly predictable.  Uncertainty, sometimes referred to as ambiguity, is amorphous and full of surprises.
  • Investors have long been asked about their attitudes toward risk, which importantly help shape portfolios.  More recently, economists have been trying to characterize aversion to ambiguity as a factor in human behavior.  Concern about uncertainty could explain phenomena as diverse as toilet paper shortages and bank runs.
  • In the first quarter as the market was rising, those with the greatest optimism held more equities.  As the market began to tumble, they were more likely to sell after the decline.  Investors with more cautious outlooks tended to ride out the volatility with only minor portfolio changes.
  • If enough people are averse to ambiguity, any major disruption in the market can trigger a series of sell responses that snowball into the kind of decline seen in the first quarter.  The best defense against these moments is an accurate appraisal of one’s emotional compass and a portfolio composition designed to anticipate that surprises will always be with us.

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