Fear of the Unknown Is Holding You Back (How to Change This)
The "Ambiguity Effect" makes you play it too safe with money
When considering two books on investing, would you be more likely to buy:
A book published by a traditional publisher with an average rating of 4 stars on 500 reviews?
Or
A self-published book with an average rating of 5 stars on 50 reviews?
That was a question I asked on Notes. Substack is home to a lot of indie writers, so I wasn’t surprised that many commenters said they would buy the self-published book. However, I suspect when it comes time to make the purchase, most people will go with the traditionally published book.
The “ambiguity effect” is a cognitive bias that describes our dislike of the unknown. Most people would rather buy an average book than take a chance on a promising—but largely unknown author who may have published a hidden gem. Since the self-published author has no track record, we distrust them.
In this article, I explain how the ambiguity effect is causing you to play it safe too often, how that hurts you financially, and what you can do to embrace more calculated risks.
Ambiguity effect; a different shade of risk aversion
When making decisions, our fear of the unknown leads us to distrust the option with a less certain outcome. This means we play it safe and choose the option with a certain outcome—even if the expected payout is lower.
You might think this sounds an awful lot like risk aversion because the two concepts are similar.
Here’s the difference:
Risk aversion: we know the probability of success/failure with both options, and we choose the one with smaller payouts but greater odds of success.
Ambiguity effect: we only know the probability of success/failure with one option, which is the option we usually choose.
You’ve heard the phrase: “No risk, no reward.”
When it comes to building wealth, risk and reward are inseparable. If you want to build wealth, you must take risks; that means embracing unknowable outcomes.
Ambiguity and investing: Failure to launch
You may have heard the saying, “Time in the market beats timing the market.”
The more susceptible you are to the ambiguity effect, the more likely you are to time the market and the less likely you are to invest in stocks at all.
A 2015 paper studied whether increases in ambiguity (future uncertainty) in the stock market impacted how people invested their money.
They found that when investors’ uncertainty about the future of the stock market increased, they sold stocks and put more money into money market funds. A money market fund is a risk-free investment with a certain outcome but minimal payout.
This is a perfect illustration of the ambiguity effect. As feelings of uncertainty rise, investors feel more comfortable with the certainty of making next to nothing in money market funds than taking an uncertain return in stocks.
The researchers also found that as ambiguity rises, households are less likely to participate in the stock market at all.
The fear of an unknown outcome reduces our willingness to invest.
This is a massive problem because we never know what will happen in the stock market. As I write about in detail in The Rational Investor, timing the market is a fool’s game, and the rational approach is to buy and hold a diversified portfolio for the long run.
As Charlie Munger would say:
“The first rule of compounding is to never interrupt it unnecessarily.”
As I write in my upcoming book, The Investor’s Mindset (available for pre-order here!), you can’t control what happens in the market or what your returns will be. The only variable an investor has 100% control of is how long they keep their money invested.
Selling stocks every time you get nervous about the future is how you lose money in the stock market.
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Fear of the unknown causes us to buy too much insurance
The insurance industry would not exist without ambiguity.
If you could predict the future with 100% accuracy and looked ahead 40 years and saw you would get into a car accident—odds are you wouldn’t want to buy car insurance (putting legal requirements aside).
But we can’t predict the future—it’s ambiguous.
So, we pay insurance companies, and in exchange, they take on our financial risks. Buying home insurance means if a hurricane blows off my roof, that’s the insurance company’s problem, not mine—speaking strictly from a financial point of view.
A 2015 paper shows how ambiguity causes us to buy too much insurance.
For losses known to be severe but have a low probability—like your house burning down—people tend to buy the right amount of insurance.
People buy too much insurance for losses that are difficult to predict, like whether we will be at fault in a car accident.
If someone were thinking rationally, they would take precautions to reduce the odds of getting in an accident. Buying winter tires is a prime example as it reduces the odds of getting in a car accident, and as a result, many insurance companies will discount your premiums when you buy them.
But the ambiguity effect clouds our judgment, and we’d rather buy more insurance than we need than take preventive measures. In the winter tires example, this is not only a waste of money but needlessly increases the odds of getting in a car accident.
Few things are less certain than starting a business
The ambiguous nature of starting a business keeps most would-be entrepreneurs clinging to a secure 9-5 paycheck.
Whether a business will succeed or fail is never known beforehand—but some are more difficult to predict than others.
If you were to buy a McDonald’s franchise, a lot of the ambiguity disappears because of the brand recognition and proven business model of buying an established franchise.
Starting a new company with potentially revolutionary technology is much less certain. Everything from whether the product will work to getting consumers to understand or care about your product is a complete mystery.
A 2020 paper provides evidence that the more ambiguous their odds of success, the less likely someone is to become an entrepreneur. It also reduces the amount of money the entrepreneur is willing to invest, which reduces the odds of the business succeeding.
In the face of ambiguity, you see more people rejecting the binary of working a 9-5 or becoming a full-time entrepreneur. Having a part-time business alongside a 9-5 can allow entrepreneurial-curious people to build a business while maintaining the stability of a paycheck.
How to embrace more risk
Like all cognitive biases, simply being aware that your brain prefers known outcomes is vital in preventing the ambiguity effect from dominating your decisions.
If you’re still reading this, congratulations, you’ve taken the first step!
But, you know what I’m about to say next…
What does the research say?
A 2014 paper found evidence that an effective way to reduce the ambiguity effect is through experience. The researchers found that the more often people make a risky bet with an unknown probability, the more comfortable they are with ambiguous outcomes.
Let’s jump back to the example of investing in the stock market.
This research would suggest that the more you invest, and the longer you stay invested, the more comfortable you are likely to be with the ambiguous nature of the stock market.
With time and experience, you become less bothered by the random nature of the stock market.
The 2015 investment paper I referenced earlier had a similar finding: more experienced and mature investors were less likely to be impacted by the ambiguity effect.
As a side note, the researchers also found that optimists were less likely to be impacted by ambiguity—which aligns with what I have written about financial optimism here and in The Investor’s Mindset.
I realize this presents a bit of a catch-22. You need experience to overcome the fear of the unknown, but the fear of the unknown might be what’s preventing you from even starting.
The best advice I have is to do your homework before investing. Educating yourself can eliminate some of the unnecessary ambiguity. But in the end, taking the first step into the unknown requires courage.
It might be scary at first, but with time and experience, you’ll become more comfortable embracing the uncertainty of life. Once those risks begin paying off, you may learn to embrace the unknown and the opportunities it provides.
Want to improve your financial decision-making? Read past editions in the Money on my Mind series
And don’t forget to pre-order your copy of The Investor’s Mindset ;)
This article is for informational purposes only. It should not be considered Financial or Legal Advice. Not all information will be accurate. Consult a financial professional before making any significant financial decisions.