Ambiguity Aversion and Panics

The rise in 'information sensitivity' across a broad cross-section of formerly informationally insensitive assets occurs due to fears of adverse selection, of buying an asset that is being sold because insiders know it is toxic. Yet it's interesting that when this occurs assets generally sell below their 'fair value' or 'net asset value' as they were in the winter of 2009, and people don't jump in and sieze this opportunity as they usually do.

Why the sudden risk aversion? Is it just because they are less wealthy? It's not clear less wealthy people are more risk averse than the more wealthy people. Is it just because they recently lost money? Consider the known fact that people would rather bet on future events than on past events of equal uncertainty, because not knowing what happened undermines competence. In experiments, a lottery ticket is worth a lot less after the drawing for most people even if they don't know what the true number is, and seemingly the seller does not either. People shy away from processes about which they think they have insufficient, as opposed to probabilistic, information, even if framed identically (eg, both with a 50% chance).

This 'ambiguity aversion' increases with the perception that others are more competent and more knowledgeable. If people choose an ambiguous option and receive a bad outcome, then they fear criticisms by others who will note they should have known better. Such criticisms are easier to counter after a pure risky choice, when a bad outcome is more easily explained as bad luck, than after an ambiguous choice. This explains the enhanced ambiguity aversion. Such social effects are called the fear of negative evaluation (FNE), basically, the fear of being evaluated a fool with hindsight.

If a bad outcome were to result from a prospect about which an agent had relatively little knowledge his failure can be blamed on his incompetence. A bad outcome resulting from a pure risky prospect, on the other hand, cannot be attributed to poor judgment. All possible information about the risky prospect was known, and a failure is simply bad luck. The key is, ex post, will you look like a sucker, or just unlucky? Investment managers can live with bad luck, but their reputation is essential and they can't be seen a fool.

Applied to the recent recession, consider that by the summer of 2008 we already had failures of Bear Stearns and Fannie Mae, two venerable institutions. It was not clear what the essence of the problem was--CDOs? Complexity? Banks? Mortgages? Copulas?--so investors simply knew that something was rotten, and it seem probable that some people knew what was going on, leaving one in the proverbial position of the guy at the poker table who doesn't know who the sucker is. This causes everyone to get alligator arms and jump into the least risky thing they can think of--the dollar, US Treasuries. With investment down, profits plummet, leading to a general recession.

A key point is that when spreads on Junk bond and Asset Backed Security spreads went well above any conceivable expected loss, we know it's a good time to invest because poor performance is never as bad as implied via risk-neutral probabilities, and it's better not to think of this as a 'risk premium' but rather an opportunity driven by people's ambiguity aversion.