The Ellsberg Paradox offers empirical proof that we favor known probabilities over unknown ones. We stay away from uncertainty and try to give higher weight to known things. Risk means that the probabilities are known.
Uncertainty means that the probabilities are unknown to us. We can make calculations and decide either making bet or not while risk involved. But when uncertainty comes, we cannot make any calculations so decision-making becomes harder.
Only in very few areas where we can count on clear probabilities: casinos, coin tosses, and probability textbooks. Often, we are left with troublesome ambiguity.
Investment – We generally mixed up when we think about risk and uncertainty while investing. We tend to keep saying that we get higher returns where the risk is higher. But actually, we get higher returns where uncertainty is higher. When things started getting certain, valuation starts reflecting certainty, and chances of making good returns reduce.
COVID-19 pandemic is an uncertainty rather than a risk, and we can see that return comes after the pandemic event.
This entire series will be reviewed with various examples from books which are “Thinking, Fast and Slow” and “The Art of Thinking Clearly“.