Ambiguity vs. Risk in Investment Decisions: A Continuous Decomposition

Geoffrey Heal and Marcella Lucchetta

No 35488, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: This paper provides a novel framework for assessing the effect of ambiguity on asset values within the Klibanoff-Marinacci-Mukerji (KMM) smooth ambiguity framework. By shifting the analysis into a continuous space of prior probabilities, we establish that ambiguity leads to an adjustment of beliefs (“ambiguity-adjusted probabilities” or “distorted probabilities”) characterized by First-Order Stochastic Dominance (FSD). Leveraging this property, we introduce a systematic economic decomposition of asset valuation separating the baseline risky valuation from the structural cost of uncertainty. Our continuous framework shows that increased ambiguity aversion depresses optimal asset demand.

JEL-codes: D81 G10 G12 Q20 (search for similar items in EconPapers)
Date: 2026-07
Note: CF EEE
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