Nobel Prize Winner Thomas Sargent on Risk, Ambiguity, and Investment Decision Making
Delegates at the 66th CFA Institute Annual Conference in Singapore were treated to a discourse on rational expectations and ambiguity from Nobel Prize winner Thomas Sargent, the William R. Berkley Professor of Economics and Business at the New York University Stern School of Business.
Investment decision making is challenging because it involves both risk and ambiguity, argued Sargent, who earned his Nobel Prize in economics in 2011 for his research on cause and effect in the macroeconomy. By risk, he means uncertainty about the future. By ambiguity, he means ignorance about the appropriate probability distribution or appropriate model. Professor Sargent contends that many financial models fail to distinguish between the two concepts and, consequently, that investors often mistake ambiguity premiums for risk premiums.
Historically, decision makers of all types have used rational expectations as a basic underlying assumption of their economic and financial models. While it has been a useful tool and was a significant leap forward, it is nevertheless an incomplete model. Sargent’s work is pioneering the way in articulating and separating the various components of risk.