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Follow-up research should document these tendencies with many more examples, and in laboratory settings. If improved predictions are our goal, it should also provide rigorous statistical models of effective updating of virgin and experienced risks. Future inquiry should consider resembled risks as well. Evidence from both terrorist incidents and financial markets suggests that we have difficulty extrapolating from risks that, though varied, bear strong similarities.

Behavioral biases such as these are difficult to counteract, but awareness of them is the first step. Requiring careful analysis of all available data could help decision makers to make better risk assessments. History has shown, however, that it is difficult to not overreact to virgin events and to downplay new evidence on experienced risks. Moving from awareness to behavioral change will be challenging, but given the importance of the decisions affected, change is essential.

RECOMMENDED READING

Fischhoff, B. (1975). “Hindsight ≠ Foresight: The Effect of Outcome Knowledge on Judgment Under Uncertainty.” Journal of Experimental Psychology: Human Perception and Performance 1, no. 3: 288-299.

Kahneman, D., and A. Tversky (1979). “Prospect Theory: An Analysis of Decision Under Risk.” Econometrica 47, no. 2: 263-292.

Kousky, C. (2010). “Learning from Extreme Events: Risk Perceptions After the Flood.” Land Economics, forthcoming.

Kunreuther, H. C., ed. (1978). Disaster Insurance Protection: Public Policy Lessons. New York: John Wiley and Sons.

Pratt, J. W., and R. J. Zeckhauser (1982). “Inferences from Alarming Events.” Journal of Policy Analysis and Management 1, no. 3: 371-385.

12

How Do We Manage an Uncertain Future?

Ambiguity Today Is Not Ambiguity Tomorrow

AYSE ÖNCÜLER

AMBIGUOUS CHOICES

The Gallup Investor Optimism index, an indicator that measures individual investors’ outlook of the current investment climate, dropped from a peak value of 178 in January 2000 to a low of minus 49 in December 2008. This dramatic drop in investors’ confidence was partly due to ambiguity (or uncertainty) aversion: With the sharp decline and growing uncertainty in the markets in 2008, many investors became pessimistic and decided to make only conservative choices. Except for very sophisticated investors, many of us do not sufficiently diversify our portfolios, preferring to hold only familiar (less ambiguous) stocks such as well-known national companies’ stocks or those of their own employer. Ambiguity about what the future looks like also explains why banks stopped lending money altogether following the crash of the subprime mortgage market.

What contributes to this ambiguity avoidance, and how do we deal with it, particularly when it concerns future events? Are we as averse to ambiguity in the future as we are ambiguity today? Not necessarily, suggests behavioral evidence. We tolerate future uncertainty more easily, and sometimes we even ignore or deny it completely.

Most decisions in life involve some degree of uncertainty about the chances of an event happening or its possible consequences: What is the probability of an earthquake in my region? Should I be concerned about the health risks associated with cell phone usage? What is the dollar amount of risk exposure I have in my retirement fund? These kinds of questions are difficult to answer.

FIGURE 12.1 Uncertainties in Choice Under Ambiguity

In particular, potential losses from natural or man-made hazards (e.g., market crashes, terrorism attacks, natural disasters, global warming) are more difficult to assess than well-defined probability examples (e.g., playing the roulette at a casino, buying a lottery ticket). This is because missing information about probabilities and outcomes causes uncertainty about one’s uncertainty. Global warming is an example: There is no unanimous agreement among scientists and policy makers about the likelihood or the economic and environmental impact of climate change at a local level. In short, it is very difficult to choose among highly