Uncertainty aversion, risk aversion, and the optimal choice of portfolio

Dow, Julian A. T.; Werlang, Sérgio Ribeiro da Costa

doi:10.4324/9780203358061_chapter_17

Cited by 89 publications

(136 citation statements)

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“…Secondly, it may explain why, even at high levels of wealth, in many countries people fail to participate in the stock market. This fact is hard to rationalize with a fixed cost of participation ), but is not inconsistent with aversion to ambiguity, as shown by Dow et al (1992), Bewley (1998) and Epstein and Schneider (2010).…”

Section: Ambiguity Aversionmentioning

confidence: 99%

The role of intuition and reasoning in driving aversion to risk and ambiguity

2013

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Using information on a large sample of retail investors and experimental data we find that risk aversion and risk ambiguity are correlated: individuals who dislike risk also dislike ambiguity. We show that what links these traits is the way people handle decisions. Intuitive thinkers are less averse to risk and less averse to ambiguity than individuals who base their decisions on effortful reasoning. We confirm this finding in a series of experiments. One interpretation of our results is that the high-speed of intuitive thinking puts intuitive thinkers at a comparative advantage in situations involving high risk and ambiguity, making them less averse to both. Consistent with this view we show evidence from the field and from the lab that intuitive thinkers perform better than deliberative thinkers when making decisions in highly ambiguous and risky environments. We also find that attitudes toward risk and ambiguity are related to different individual characteristics and wealth. While the wealthy are less averse to risk, they dislike ambiguity more, a finding that has implications for financial puzzles. JEL classification: D81; D83.

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Section: Ambiguity Aversionmentioning

confidence: 99%

The role of intuition and reasoning in driving aversion to risk and ambiguity

2013

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“…The limited attention hypothesis predicts that the InnOrig effect should increase with valuation uncertainty, the fraction of inattentive investors, and the sensitivity of future profitability to InnOrig. Intuitively, when the prior uncertainty about the value of the stock (without any conditioning on InnOrig) is higher, heavier weight should optimally be 18 Such models (see, e.g., Dow and Werlang 1992;Chen and Epstein 2002;Cao, Wang, and Zhang 2005;and Bossaerts et al 2010) imply that when investors perceive higher uncertainty about an investment opportunity, they view it more skeptically. For example, in Cao et al (2005), conglomeration causes a price discount owing to the difficulty of evaluating complex firms.…”

Section: Return Predictive Power Of Innovative Originalitymentioning

confidence: 99%

Innovative Originality, Profitability, and Stock Returns

Hirshleifer

Hsu

2017

The Review of Financial Studies

178

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“…Gilboa and Schmeidler (1989) build a model where agents become extremely cautious and consider the worst-case among the possible outcomes, that is, agents are uncertainty averse and use maxmin strategies when faced with Knightian uncertainty. Dow and Werlang (1992) apply the framework of Gilboa and Schmeidler (1989) to the optimal portfolio choice problem and show that there is an interval of prices within which uncertainty-averse agents neither buy nor sell the asset. Routledge and Zin (2004) and O'Hara (2005, 2008) use Knightian uncertainty and agents that use maxmin strategies to generate widening bid-ask spreads and freeze in financial markets.…”

Section: Related Literaturementioning

confidence: 99%

Rollover Risk and Market Freezes

2010

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The sub-prime crisis of 2007 and 2008 has been characterized by a sudden freeze in the market for short-term, secured borrowing. We present a model that can explain a sudden collapse in the amount that can be borrowed against assets with little credit risk. The borrowing in this model takes the form of asset-backed commercial paper that has to be rolled over several times before the underlying assets mature and their true value is revealed. In the event of default, the creditors (holders of commercial paper) can seize the collateral. We assume that there is a small cost of liquidating the assets. The debt capacity of the assets (the maximum amount that can be borrowed using the assets as collateral) depends on how information about the quality of the asset is revealed. In one scenario, there is a constant probability that "bad news" is revealed each period and, in the absence of bad news, the value of the assets is high. We call this the "optimistic" scenario because, in the absence of bad news, the expected value of the assets is increasing over time. By contrast, in another scenario, there is a constant probability that "good news" is revealed each period and, in the absence of good news, the value of the assets is low. We call this the "pessimistic" scenario because, in the absence of good news, the expected value of the assets is decreasing over time. In the optimistic scenario, the debt capacity of the assets is equal to the fundamental value (the expected NPV), whereas in the pessimistic scenario, the debt capacity is below the fundamental value and is decreasing in the liquidation cost and frequency of rollovers. In the limit, as the number of rollovers becomes unbounded, the debt capacity goes to zero even for an arbitrarily small default risk. Our model explains why markets for rollover debt, such as asset-backed commercial paper, may experience sudden freezes. The model also provides an explicit formula for the haircut in secured borrowing or repo transactions.J.E.L. Classification: G12, G21, G24, G32, G33, D8.

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Uncertainty aversion, risk aversion, and the optimal choice of portfolio

Cited by 89 publications

References 0 publications

The role of intuition and reasoning in driving aversion to risk and ambiguity

The role of intuition and reasoning in driving aversion to risk and ambiguity

Innovative Originality, Profitability, and Stock Returns

Rollover Risk and Market Freezes

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