The Ambiguity Aversion

“On the road from the City of Skepticism, I had to pass through the Valley of Ambiguity.” - Adam Smith

Watching with interest the continuation of the rally in Asian equities in general and high beta in particular, when it came to selecting our chosen title we decided yet again to go for a behavioral psychology analogy. Ambiguity aversion, or uncertainty aversion, is the tendency to favor the known over the unknown, including known risks over unknown risks. Ambiguity aversion has also been documented in real-life situations, when, for example, it leads people to avoid participating in the stock market, which has unknown risks (Easley & O’Hara, 2009). As well, “Ambiguity Aversion” can drives portfolio-level consequences as posited indicated in May 2019 written by AllAboutAlpha on the financial site Seeking Alpha in the article entitled “Accommodating Ambiguity Aversion In Portfolio Modeling”:

“A recent paper discusses the portfolio-level consequences of this aversion.

The paper, written by Valery Polkovnichenko and Hui (Grace) Wang, explains that for an ambiguity-neutral investor, "adding active portfolio with statistically significant alpha always implies efficiency gain relative to the optimal portfolio of factors." But that is not the case for an ambiguity-averse investor, who must get an efficiency gain above a certain threshold for the new active alpha to be worthwhile. The size of that threshold will depend on uncertainty about the factors, and about the expected returns of the active portfolio.” - AllAboutAlpha

As an illustration about “asset exclusion” was many asset managers continued being very underweight Italian Government Bonds (BTPs) following Mario Draghi ECB Supremo “Whatever it takes” moment in August 2012 we think. As well the Chinese re-opening is offering some support to all related to China, from luxury stocks, to basic materials, whereas uncertainties around the path of the Fed as well as renewed Kabuki theater drama surrounding debt ceiling debate in the United States on top of conflicting macro news might have been weighting on current US exposure over Emerging Markets but we ramble again.

In this conversation, we would like to look at potential building pressure coming again when it comes to inflation with China re-opening and asset classes, and what it entails from an “Ambiguity Aversion” exposure.