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Real Investments under Knightian Uncertainty

TL;DR: In this paper, a model of real investments with Knightian uncertainty is proposed, where decision makers deviate from expected utility theory by showing excessive risk aversion and focusing on no regret moves.
Abstract: In a model of real investments with Knightian uncertainty, decision makers deviate from expected utility theory by showing excessive risk aversion and focusing on no regret moves. Within the model, a positive net present value is no longer sufficient to ensure that a real investment is undertaken. Furthermore, the value of being able to hedge increases drastically. The model could explain deviations from the net present value rule in industries where Knightian uncertainty is high. For example, high hurdle rates for venture capital, and stalled investments in several broadband markets are consistent with the model.
Citations
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Posted Content
TL;DR: In this article, the authors survey a sample of major institutional investors via a web questionnaire and find that the endowments in their sample typically had a relatively short history of real estate investment, but planned to increase their allocation to the asset class - more so than pension funds.
Abstract: In this paper we address the factors influencing the institutional decision to allocate resources to real estate. We survey a sample of major institutional investors via a web questionnaire. They were willing to answer questions about their target real estate allocation, their plans to increase or decrease their allocation, the major reasons for investing in real estate, and views on the major risks and relative expense of doing so. We find that the endowments in our sample typically had a relatively short history of real estate investment, but planned to increase their allocation to the asset class - more so than pension funds. We also find uncertainty about use of historical data to be a significant factor in the allocation choice.

45 citations


Cites background from "Real Investments under Knightian Un..."

  • ...Walden (2004) shows how uncertainty – as opposed to risk – can lead to high investment hurdle rates and under-investment in a setting in which decisions are irreversible....

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01 Jan 2016
TL;DR: Klein and Bawa as mentioned in this paper consider the problem of portfolio selection under uncertainty and show that for most risk-averse individuals, the optimal portfolio choice is a portfolio with lower expected portfolio return than the one chosen via traditional analysis.
Abstract: THE EFFECT OF ESTIMATION RISK ON OPTIMAL PORTFOLIO CHOICE UNDER UNCERTAINTY Roger W. Klein and Vijay S. Bawa* Choice under uncertainty may be viewed as choice between alternative probability distributions of returns. Under Von Neumann and Morgenstern's assumptions, an indivi? dual' s optimal choice is a distribution that maximizes the expected utility of returns. In the theoretical analysis, the distribution functions are assumed to be known. How? ever, in most realistic cases, the distributions of returns are unknown and are estimated using available economic data. The traditional mode of analysis is to neglect the esti? mation risk and use the estimated distribution (in lieu of the true distribution) in determining the optimal choice under uncertainty. In this paper, we consider the port? folio choice problem and determine the effect of estimation risk on an individual's op? timal choice under uncertainty. We first analyze the case most frequently considered in the financial economics literature where the joint distribution of security returns is multivariate normal. The individual has "non-informative" priors about the unknown parameters and has the same number of observations available on each security return to estimate the unknown para? meters. We show that when the estimation risk is explicitly considered, the admissible set of portfolios for all individuals (including risk-averse, risk-neutral, risk-seeking, and Friedman-Savage type individuals) is the same as the one obtained by traditional analysis. However, more importantly, the optimal choice for an individual, a point in this admissible set of portfolios, is different from the one selected using the tradi? tional analysis. Moreover, as intuitively expected, for most risk-averse individuals, the optimal portfolio choice is a nortfolio with lower expected portfolio return than the one chosen via traditional analysis. We also consider the above portfolio selection prob? lem when there is a differential amount of information available to estimate the para? meters of each security, and show that a risk-averse individual will want to invest more heavily in those securities about which he has most knowledge. We also examine the situa? tion where means and variances are dependent in the prior (e.g., one might believe that securities with higher means also have higher variances). For both these frequently encountered cases, we show that the admissible set of portfolios, and consequently the op? timal choice for any individual, is still obtained by a "mean-variance" selection rule. However, it is very different from the well-known mean-variance selection rule used in the financial economics literature. Bell Laboratories, Holmdel, N.J. The authors acknowledge helpful discussions with our colleague, R. D. Willig, and also thank members of the Holmdel Economic Theory Workshop at Bell Laboratories for stimulating discussions.

36 citations

Journal ArticleDOI
TL;DR: In this article, the authors focus on the direct property investment market and show that economic policy uncertainty (EPU) affects investment decisions and performance, yet research in this area has overlooked the direct properties investment market.
Abstract: It is widely established that economic policy uncertainty (EPU) affects investment decisions and performance, yet research in this area has overlooked the direct property investment market. This ar...

14 citations


Cites background from "Real Investments under Knightian Un..."

  • ...Walden (2004) modelled venture capitalists and found that they tended to hedge against high uncertainty but, if they were unable to hedge, and if the potential political decisions were perceived as irreversible, investment would stall and, when resumed, lead to higher hurdle rates....

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Journal ArticleDOI
TL;DR: The authors investigated the variation in proxy returns and proxy rental yields across 34 major European cities, using a handful of independent variables that should account for the influence of market risk, inflation, and liquidity.
Abstract: We conduct an exploratory analysis using proxy measures of cross-sectional returns and rental yields in residential real estate. Asset pricing models predict that expected returns should exhibit some sensitivity to one or several fundamental variables that represent a common source of undiversifiable risk. Residential real estate, just like works of art and collectibles, is unique because it represents both an investment vehicle and a durable consumption good. Its pricing and returns should thus reflect both the benefits from portfolio diversification and the effect of supply and demand. In this paper, we investigate the variation in proxy returns and proxy rental yields across 34 major European cities, using a handful of independent variables that should account for the influence of market risk, inflation, and liquidity. In spite of obvious limitations stemming from our sample, we find that the explanatory power of our model is unusually high for a cross-sectional data analysis. Some of our findings concur with other studies showing that in spite of strong segmentation, real estate markets respond to the same structural risk factors. A good portion of our results, however, is hard to explain and interpret. Either we need to take into account cultural differences between Eastern and Western Europe as part of a behavioral approach, or we have to concede that we have been misled by the mismatch in the level of aggregation and the crude estimation of the dependent variables.

6 citations

References
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Journal ArticleDOI
Daniel Ellsberg1
TL;DR: The notion of "degrees of belief" was introduced by Knight as mentioned in this paper, who argued that people tend to behave "as though" they assigned numerical probabilities to events, or degrees of belief to the events impinging on their actions.
Abstract: Are there uncertainties that are not risks? There has always been a good deal of skepticism about the behavioral significance of Frank Knight's distinction between “measurable uncertainty” or “risk”, which may be represented by numerical probabilities, and “unmeasurable uncertainty” which cannot. Knight maintained that the latter “uncertainty” prevailed – and hence that numerical probabilities were inapplicable – in situations when the decision-maker was ignorant of the statistical frequencies of events relevant to his decision; or when a priori calculations were impossible; or when the relevant events were in some sense unique; or when an important, once-and-for-all decision was concerned. Yet the feeling has persisted that, even in these situations, people tend to behave “as though” they assigned numerical probabilities, or “degrees of belief,” to the events impinging on their actions. However, it is hard either to confirm or to deny such a proposition in the absence of precisely-defined procedures for measuring these alleged “degrees of belief.” What might it mean operationally, in terms of refutable predictions about observable phenomena, to say that someone behaves “as if” he assigned quantitative likelihoods to events: or to say that he does not? An intuitive answer may emerge if we consider an example proposed by Shackle, who takes an extreme form of the Knightian position that statistical information on frequencies within a large, repetitive class of events is strictly irrelevant to a decision whose outcome depends on a single trial.

7,005 citations


"Real Investments under Knightian Un..." refers background in this paper

  • ...To see how Knightian uncertainty influences decision making, let us review a variation of the classical Ellsberg paradox (Ellsberg 1961):...

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  • ...To see how Knightian uncertainty influences decision making, let us review a variation of the classical Ellsberg paradox (Ellsberg 1961): Example 1 : Ellsberg three-color example An urn contains 90 balls....

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Posted Content
TL;DR: Prospect Theory as mentioned in this paper is an alternative theory of individual decision making under risk, developed for simple prospects with monetary outcomes and stated probabilities, in which value is given to gains and losses (i.e., changes in wealth or welfare) rather than to final assets, and probabilities are replaced by decision weights.
Abstract: Analysis of decision making under risk has been dominated by expected utility theory, which generally accounts for people's actions. Presents a critique of expected utility theory as a descriptive model of decision making under risk, and argues that common forms of utility theory are not adequate, and proposes an alternative theory of choice under risk called prospect theory. In expected utility theory, utilities of outcomes are weighted by their probabilities. Considers results of responses to various hypothetical decision situations under risk and shows results that violate the tenets of expected utility theory. People overweight outcomes considered certain, relative to outcomes that are merely probable, a situation called the "certainty effect." This effect contributes to risk aversion in choices involving sure gains, and to risk seeking in choices involving sure losses. In choices where gains are replaced by losses, the pattern is called the "reflection effect." People discard components shared by all prospects under consideration, a tendency called the "isolation effect." Also shows that in choice situations, preferences may be altered by different representations of probabilities. Develops an alternative theory of individual decision making under risk, called prospect theory, developed for simple prospects with monetary outcomes and stated probabilities, in which value is given to gains and losses (i.e., changes in wealth or welfare) rather than to final assets, and probabilities are replaced by decision weights. The theory has two phases. The editing phase organizes and reformulates the options to simplify later evaluation and choice. The edited prospects are evaluated and the highest value prospect chosen. Discusses and models this theory, and offers directions for extending prospect theory are offered. (TNM)

4,185 citations

Book ChapterDOI
TL;DR: In this paper, an axiom of comonotonic independence is introduced, which weakens the von Neumann-Morgenstern axiom for independence, and the expected utility of an act with respect to the nonadditive probability is computed using the Choquet integral.
Abstract: An act maps states of nature to outcomes; deterministic outcomes as well as random outcomes are included. Two acts f and g are comonotonic, by definition, if it never happens that f(s) >- f(t) and g(t) >- g(s) for some states of nature s and t. An axiom of comonotonic independence is introduced here. It weakens the von Neumann-Morgenstern axiom of independence as follows: If f >- g and if f, g, and h are comonotonic, then cff +(l-a)h>-ag+(1 -ac)h. If a nondegenerate, continuous, and monotonic (state independent) weak order over acts satisfies comonotonic independence, then it induces a unique non-(necessarily-)additive probability and a von Neumann-Morgenstern utility. Furthermore, one can compute the expected utility of an act with respect to the nonadditive probability, using the Choquet integral. This extension of the expected utility theory covers situations, as the Ellsberg paradox, which are inconsistent with additive expected utility. The concept of uncertainty aversion and interpretation of comonotonic independence in the context of social welfare functions are included.

2,898 citations


"Real Investments under Knightian Un..." refers background or methods in this paper

  • ...To model decision making under Knightian uncertainty, we will use an intertemporal version of the multiple priors expected utility (MEU) model by Gilboa and Schmeidler (1989) (also known as the Maxmin Expected Utility model)....

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  • ...We generalize the Gilboa & Schmeidler model to an intertemporal setting (For details, see Appendix C)....

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  • ...Our approach to incorporating Knightian uncertainty into decision making follows the Gilboa and Schmeidler max-min theory....

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  • ...The Gilboa & Schmeidler (GS) approach to decision making follows the Anscombe & Aumann (AA) model in that it works on two-stage lotteries, where the first stage is a “state of the world horse lottery”, and the second is an “objective roulette lottery”....

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  • ...The rest of this paper is organized as follows: In Section 1, we review the multiple priors expected utility model by Gilboa and Schmeidler (1989), and motivate the use of multiple priors with a simple example....

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Journal ArticleDOI
TL;DR: The authors describes and analyzes the structure of VC organizations, focusing on the relationship between investors and venture capitalists and between venture-capital firms and the ventures in which they invest, and contrasts VC organizations with large, publicly traded corporations and with leveraged buyout organizations.

2,686 citations


"Real Investments under Knightian Un..." refers background in this paper

  • ...Difficulties to achieve diversification (leading to a priced idiosyncratic risk), and the illiquidity of venture capital investments will also lead to higher required discount rates (Sahlman 1990)....

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  • ...In a similar survey for Sweden’s 500 largest companies, Sandahl and Sjögren (2003) show that almost 35% of the respondents do not use NPV based methods for capital budgeting. Although the fraction of companies using NPV analyses is steadily rising2, there is still a significant fraction of companies that use capital budgeting analyses that are not NPV based. The companies in the surveys are not small (the smallest company in the survey has revenues of about $100 million in Graham and Harvey (2001) and $50 million in Sandahl and Sjögren (2003)) and considering the extent to which the NPV rule has been taught to MBA students over the last decades one might expect that the numbers would be higher....

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  • ...In a similar survey for Sweden’s 500 largest companies, Sandahl and Sjögren (2003) show that almost 35% of the respondents do not use NPV based methods for capital budgeting....

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  • ...…high discount rates could be required to compensate venture capitalists for taking an active role in management, to adjust for biases in financial projections from entrepreneurs, or alternatively to reflect that the cash flow estimates are conditional on the project being successful (Sahlman 1990)....

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  • ...We mention a sample: For venture capital, high discount rates could be required to compensate venture capitalists for taking an active role in management, to adjust for biases in financial projections from entrepreneurs, or alternatively to reflect that the cash flow estimates are conditional on the project being successful (Sahlman 1990)....

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Posted Content
TL;DR: In this article, the authors present some simple models of irreversible investment, and show how optimal investment rules and the valuation of projects and firms can be obtained from contingent claims analysis, or alternatively from dynamic programming.
Abstract: Most investment expenditures have two important characteristics: First, they are largely irreversible; the firm cannot disinvest, so the expenditures are sunk costs. Second, they can be delayed, allowing the firm to wait for new information about prices, costs, and other market conditions before committing resources. An emerging literature has shown that this has important implications for investment decisions, and for the determinants of investment spending. Irreversible investment is especially sensitive to risk, whether with respect to future cash flows, interest rates, or the ultimate cost of the investment. Thus if a policy goal is to stimulate investment, stability and credibility may be more important than tax incentives or interest rates. This paper presents some simple models of irreversible investment, and shows how optimal investment rules and the valuation of projects and firms can be obtained from contingent claims analysis, or alternatively from dynamic programming. It demonstrates some strengths and limitations of the methodology, and shows how the resulting investment rules depend on various parameters that come from the market environment. It also reviews a number of results and insights that have appeared in the literature recently, and discusses possible policy implications.

2,230 citations