By Dave DeFusco
Innovation is always a leap into the unknown. Companies spend billions on research and development (R&D), hoping that today’s experiments will become tomorrow’s medicines, devices or clean technologies. But whether firms push ahead or hold back depends not just on uncertainty in general, but on two very different kinds of it: risk and ambiguity.
in the Journal of Financial and Quantitative Analysis by Professors S. Abraham Ravid and Gabriela Coiculescu at żŰżŰ´«Ă˝â€™s Sy Syms School of Business explores this distinction in detail, using historical data for U.S. public firms. Risk, they found, can sometimes encourage innovation. Ambiguity, by contrast, consistently discourages it.
“Risk is when you don’t know the outcome, but you know the odds,” said Dr. Ravid, Sy Syms Professor of Finance. “Rolling a die is risky—you don’t know what number will land, but you know each side has a one-in-six chance.”
Ambiguity is trickier; it’s when you don’t even know the odds. “It’s like flipping a coin without knowing if it’s fair,” said Dr. Coiculescu, a clinical associate professor of finance. “You’re uncertain not just about the outcome, but about how likely each outcome really is.”
That difference between the known unknowns of risk and the unknown unknowns of ambiguity shapes how firms behave when deciding whether to innovate.
To analyze innovation decisions, the researchers use a finance lens called “real options.” Just like investors can buy financial options—paying a small price today for the chance at a big payoff later—companies can think of R&D as an option. They spend money on research to keep alive the possibility of a breakthrough. If the payoff looks promising, they go ahead; if not, they walk away.
Imagine a pharmaceutical company considering a new drug. To bring it to market will eventually require a $100 investment in production. If successful, the drug could be worth $120; if not, only $80. If the drug is successful, the option pays off the difference: $120 minus $100 equals $20. But if it fails, the firm shelves the project and loses nothing more.
Now, suppose the probabilities are known—50% chance of success, 50% chance of failure. In that case, the expected option value is simply: half of $20, or $10.
If the drug’s payoff becomes more volatile—say it could be worth $130 instead of $120, or $70 instead of $80—the average outcome hasn’t changed, but the spread has widened. With more upside in play, the option value rises to $15. In other words, risk actually makes the option more valuable because the potential reward of success outweighs the downside.
Now change the setup: the drug’s payoff remains $120 or $80, but the probabilities are uncertain. Instead of a clear 50/50 split, the true chances could be 40/60 or 60/40—and the company has no way to know which.
Managers who dislike ambiguity—ambiguity-averse—don’t treat these possibilities as equal. Instead, they weigh the downside more heavily. As a result, the value of the option is less than $10. How much less depends on the degree of ambiguity aversion: the more ambiguity averse the managers are, the lower the value of the option. For example, if the ambiguity aversion is 2, the authors show that the value of the option falls to 9.8. For the same ambiguity aversion, if ambiguity increases further—say the odds could be 30/70 or 70/30—the option value falls to 9.2.
The lesson is striking. While more risk can raise the value of innovating, more ambiguity lowers it. Risk encourages firms to keep their labs running, since the upside could be large. Ambiguity, however, pushes them to delay or avoid action altogether.
“Our results show that ambiguity consistently reduces innovation,” said Dr. Coiculescu. “Firms facing more ambiguity spend less on R&D, file fewer patents and earn fewer citations.”
Notably, while ambiguity has an overall negative effect on both R&D and patents, the effect of ambiguity on R&D is stronger for firms that have not yet filed a large number of successful patents, whereas the effect of ambiguity on patents and citations is stronger for patent-intensive high-tech firms.
These findings imply that ambiguity affects firms at different stages of the innovation process. For firms that don’t yet have a solid track record of successful innovations, R&D investment is the dimension of innovation activities over which managers exercise more control relative to patenting decisions. In contrast, in patent-intensive firms, managers have more discretion over which innovations to patents and over the timing of patent filings, perhaps delaying patenting for strategic reasons or until uncertainty, as reflected in ambiguity and risk, decreases.
At its heart, the study highlights something intuitive but often overlooked: uncertainty comes in different forms, which don’t affect innovation in the same way. Risk can inspire bold moves; ambiguity breeds hesitation.
“Every breakthrough we celebrate today,” said Dr. Ravid, “is the result of someone choosing to innovate despite uncertainty. By understanding how risk and ambiguity work, we can make it easier for firms to take those leaps into the unknown.”
