Ambiguity Bias

Definition

Ambiguity bias is the preference for known risks over unknown risks. Investors avoid opportunities where probabilities are unclear — even if potential returns are high — leading to suboptimal diversification or opportunity loss.

Case Study

A salaried man in Chennai was offered two health insurance plans by his company. The first plan clearly listed hospital room limits, maternity benefits, and cashless network hospitals. The second plan was newer and potentially offered better coverage, but its brochure was vague about exclusions, pre existing conditions, and claim limits. Even though the second plan might have been more comprehensive, he chose the first one because its details were easier to understand. The lack of clarity in the second option made him avoid it, as he felt more comfortable choosing something familiar and well explained, even at the cost of missing better benefits.

Historical Reference

Rooted in Ellsberg’s Paradox (1961), ambiguity bias challenges traditional models assuming rational risk evaluation. It’s especially relevant in modern finance with constant product innovation.