# THE DIFFERENCE BETWEEN RISK AND UNCERTAINTY Ambiguity Aversion

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.

# WHEN YOU HEAR HOOFBEATS, DON’T EXPECT A ZEBRA Base-Rate Neglect

Base-rate neglect: a disregard of fundamental distribution levels. The majority of the people ignore statistical data to conclude.

Representativeness—ignoring both the base rates and the doubts about the veracity of the description.

We focus on the other aspects rather than statistics for making a decision. For example, selecting a player based on his build and look rather than his past performance statistics.

Selection of investment by story prevailing at street rather than the past performance of the company. This falls under this bias.

When the stereotypes are false and the representativeness heuristic will mislead, especially if it causes people to neglect base-rate information that points in another direction. Even when the heuristic has some validity, exclusive reliance on it is associated with grave sins against statistical logic.

Investment – We know that very few companies survive after 10 years of operations. So, when we have seen any companies that come as a next google, Facebook, Amazon, Infosys, Dmart, etc. then we should have data which suggests that if the company has not seen 10 years of journey, then we should stay away from it.

When we make any decisions, we should not avoid statistical data. Because avoiding such data can misguided us and we ended up taking miserable decisions.

It is also logical that low return ratio companies will not be going to give a higher return to us (else we have bought it at deep discount-then also the lower probability to give multifold returns), then also when we have any good narrative about the company, we start chasing it. Never avoid the voice of numbers because it can tell us a real story.

We focus on the stories of management, industry, economic growth potential but forget to focus on the past performance of the company. If past performance says that the company is not strong enough to perform then enough external opportunities also cannot do anything. But people follow stories and avoid base rates or probabilities and end up with blunders.

This entire series will be review with various examples from books which are Thinking, Fast and Slow and The Art of Thinking Clearly.

# WHY THE LAST COOKIE IN THE JAR MAKES YOUR MOUTH WATER Scarcity Error

When we see that something is different, unique, and having a shortage then we love to own it. That things attract us and we see them as more valuable than others. Rare is valuable. The scarcity error is as old as mankind.

We need to assess products and services solely based on their price and benefits. It should be of no importance if an item is disappearing fast, nor if others are also interested to buy it.

Business – Many business houses try to attract customers by creating a scarcity of their products. They show the availability of only a limited number of products which forces customers to make any impulsive decisions. When we make an impulsive decision then we scarify rational thinking.

Investment – Few listed businesses are unique, different than others, well managed. Such businesses are few so People are attracted towards such businesses and suddenly those become more valuable and started trading at a higher valuation. This is what we have experienced about the quality companies in the recent stock market cycle.

Many times, businesses getting premium as an only listed company on the bourse but that should not be the only reason to invest in a company or to give a higher premium to the business. People mostly fear missing out (FOMO) particular opportunity and run behind it, so that float available for a particular stock starts reducing and demand for it starts increasing which will increase the price of a stock.

We should check whether the company has fundamental value compared to the price commanding on the bourse. If the company is not fundamentally stronger then it is no right way to chase uniqueness of business or only listed company or low shares floating in the market. We should have well-defined philosophy to invest in businesses and if the stock does not fall under it then we must avoid it. Also, we should not take a speedy decision, speedy decisions can be harmful. We are not going to miss any opportunity, the market has thrown opportunities before our birth and also going to throw after our death. We remain or not, opportunities in the market always are there to serve.

This entire series will be review with various examples from books which are Thinking, Fast and Slow and The Art of Thinking Clearly.

# WHY EVIL STRIKES HARDER THAN GOOD Loss Aversion

Many of the time, we have to make decisions from options, there is a risk of loss and an opportunity for gain, and we must decide whether to accept the gamble or reject it.

It has been proven that, emotionally, a loss ‘weighs’ about twice that of a similar gain. Social scientists call this loss aversion. “Losses loom larger than gains” and that people are loss averse.

Business – When we show fear of loss to people and sell our products then it will become easy to sell our products to them. The firm has its own entitlement, which is to retain its current profit. If it faces a threat of loss, it is allowed to transfer the loss to others.

Investment – When there is an increase in a stake, our loss aversion also increases with it. When we have invested in stocks and the price of it falls and we know that we have incurred loss but we do not book it. So, we sit on the stock, even if the chance of recovery is small and the probability of further decline is large. If we book loss then it becomes real and that is more painful. Fear of loss stops us from booking loss though it has already been incurred.

We should make a basic calculation of what would be future cash flow generation from the company and what if our assumption get fails. These basic calculations help to understand the risk and return scenario so that we can make a rational decision. And also, can use the margin of safety concept properly. We should be ready with a calculation that mentioned what can be a probability of losing some % of our current net worth if an investment does not work according to our plan so that we get mentally prepared in advance and also make a decision accordingly.

This entire series will be review with various examples from books which are Thinking, Fast and Slow and The Art of Thinking Clearly.