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A traditional tenet of investment theory is that
investors are rational beings who always attempt to maximize expected utility based on their expectations of future returns
and asset co-movements. Asset pricing models have, since their inception, been used
to predict the future returns on various investments. Such models help evaluate
the historical performance of portfolios and the risks involved. Traditional asset
pricing models have demonstrated only limited ability to predict future returns, thus making
it difficult for the investors to gain an idea about the future distribution of asset
returns. This is also difficult because an enormous amount of information flows continuously
into the market. This implies that investors find themselves uncertain at times about
future asset returns, despite such high volumes of information. This can be understood in
the context of the uncertainty associated with the probability distribution.
An investor is uncertain while estimating future asset returns. People choose
the alternative with a known probability over an ambiguous one. Ellsberg (1961)
first identified the concept of ambiguity aversion, which occurs when people prefer to bet
on lotteries with known probabilities of winning, rather than those with ambiguous
outcome distributions. Heath and Tversky (1991) identified a related concept, known as
the competence effect, which states that ambiguity aversion is affected by the
subjective competence level of those who are involved in the process. The competence effect can
be understood with the help of an example cited by Heath and Tversky (1991). In their
study, a participant answers a set of knowledge questions concerning history, geography, or
sports. For each question, the participant is asked to report his/her confidence in the answer,
i.e., the subjective probability that the answer given by him/her is correct. Finally,
the participant is presented with two choices, either to bet on his/her own answer, or to
bet on a lottery in which the probability of winning is the same as the stated confidence
level. It was found that when people are very sure about the subject matter (i.e., they
feel `competent'), they are more likely to rely on their own judgments, rather than on
a matched chanced lottery. On the contrary, when people feel less sure, they might,
choose the other alternative, i.e., the matched-chanced lottery. Thus, it is obvious that
when people feel competent in an area, they bet on their own judgments even if it is
not perfectly right. But when they feel themselves not so competent, they would rather
like to play safe and choose the ambiguous option. Therefore, it can be said that the
effects of ambiguity aversion are subjected to the level of competence of the participants. |
