Researchers have known for a long time that risk aversion can have a huge impact on decision making, but more recently they have been studying the role of a particular type of risk aversion—a dislike of uncertainty or ambiguity. In ambiguous situations, individuals don’t know the probabilities of different outcomes, so they are more likely to stick with something that seems like a surer bet.
Two researchers at the Kenan-Flagler Business School at the University of North Carolina in Chapel Hill have been studying the impact of ambiguity aversion on decision making: Paolo Fulghieri, the Macon G. Patton Distinguished Professor and area chair of finance, and David Dicks, an assistant professor of finance.
Fulghieri and Dicks point to the Keynesian example of a bucket filled with red and blue balls. Participants have the choice of receiving US$50 now—or $100 if they pull a blue ball out of the bucket. Most people chose the $50 certainty over the 50-50 probability. But it’s more complex when there are two containers. Bucket A has 50 red and 50 blue balls; Bucket B has 100 balls, but participants don’t know the ratio of red and blue ones. Participants can select either hue as their winning color, as well as which bucket to draw from. If they choose balls in the right color, they receive $100. Most people will choose from Bucket A, because they know their chances are 50-50; they avoid the ambiguity of Bucket B.
Fulghieri and Dicks have written three papers that propose mathematical models for understanding how ambiguity aversion affects decision making, especially in areas such as innovation, financial system risk, and corporate governance.
In terms of innovation, they note that investors must decide whether to fund inventions based on incomplete information. They predict that uncertainty-averse investors will be more optimistic when they can invest in additional innovative ventures to better manage risk. They also predict that these diversified investments will create innovation waves that lead more entrepreneurs to invest resources into uncertain ventures.
A working paper on ambiguity aversion by Fulghieri and Dicks is available at: daviddicks.web.unc.edu/research/innovation.