Continued extreme anxiety is boosting our confidence, says Ardevora's Lang

By Jeremy Lang, partner and co-founder of Ardevora Asset Management – Humans are notoriously poor at forming subjective probabilities – the mind prefers dealing with absolutes: ‘yes’ or ‘no’. 

We are also very susceptible to anchoring when forming our views. The most similar thing we can remember acts as a powerful anchor for our views of the future. Overemphasis of recent information, poor subjective probability estimation and anchoring can make bad judgments easy when a new source of unpredictability arrives with a violent shock.

The path of learning about a new thing should feel like a gradual sifting and adjusting of probabilities for a wide range of outcomes; a sort of continuous error-correct flow through time. In reality, it tends to be more like an exercise in extreme views. Either a series of gut-wrenching lurches from one extreme to another, or a violent lurch to one extreme view early on – based on anchoring to something in our past experience – where we remain marooned because we dislike the feeling of admitting we are wrong.

The events of the last six months have all of the ingredients for an environment made for bad judgment. The range of plausible outcomes is extremely wide, and the path towards each of them is shifting rapidly as new information emerges and as people react and change behaviour in unpredictable ways. It is extremely easy to be wrong. It is also extremely easy to be tempted to anchor one’s view to something inappropriate and then to stubbornly stick to this. Being wrong does not necessarily lead to bad judgment. What makes for bad judgment is an inability to learn, to make an error, recognise the error and then form another, better view.

Searching the precedent bank

Looking back to the start of the year, investors viewed 2020 with considerably more optimism than the beginning of 2019. Similarly, CEOs were cautiously optimistic. We were a little more nervous. It is easier to make money in stocks when anxiety and scepticism about prospects is high – it is a bit tougher if investors are already quite hopeful.

By the end of March our views had changed a lot. We recognised a new source of unpredictability was emerging and we thought all three of our groups of interest – investors, analysts and CEOs – were surprisingly relaxed. We were worried a major supply side shock was coming, from the enforced factory shutdowns in China from the spread of Covid-19. We worried this could trigger a feedback loop that could impact demand. In our experience, when the environment changes, CEOs often can ‘create’ risk by being stubborn and not admit they could be wrong. Analysts and investors do not like it when CEOs are wrong and start to lose trust. These signs began emerging in February.

We were wrong. We did not work out Covid-19 was already on its way out of China and its impact would cascade rapidly around the world. We, like most people, metaphorically reached for the precedent bank. Was it like SARS, MERS or the Spanish Flu? News headlines became swamped with R-numbers, infection curves and mortality stats. Stock markets became sensitive to the daily release of infection rates. Almost everyone became very anxious, about the health risk and the economic impact. We all reached for the precedent bank again. Was this like 2008, 1998 or 1929?

It is not like any of these. The characteristics of the virus are different, the world is different, the way everyone has responded, including governments, is different. Everything suddenly feels very unpredictable. Our view has changed a lot in the last three months. We have gone from believing everyone else had underreacted to now believing pretty much everyone else has overreacted.

It seems easier to overreact

First, CEOs' plans and beliefs have changed. No one is dismissing the current situation as a flash in the pan. Most are focused, unusually, on risk and what could go wrong. Second, we are pretty sure most analysts and investors are worried. From a psychological perspective, shocks tend to leave scars, which can act as powerful anchors. Just because some market indices have rebounded, does not mean anxiety has gone. The scars remain. Third, Governments are worried. They have unleashed unprecedented measures to prop up the economy, at an unprecedented speed.

This combination makes us a lot less worried. Yes, we still worry about second waves of infection and the amount of debt. But we do not worry that from here things will not gradually get better than most other people expect. We hold this view because, for the moment, most people have lurched to a new anchor – the first infection wave of Covid-19.

We think the chances of a nasty outcome are diminishing, and are generally less than commonly perceived, while the chances of a surprisingly benign outcome are rising and are generally higher than is commonly perceived.

This shift has made us more interested in buying stocks where we think we can see unusual investor and analyst anxiety. We are particularly drawn to those where we can see evidence CEOs have shifted behaviour to become more focused on controlling risk. There are generally more stocks with this combination. This combination is also more likely to be rewarding in an environment where, we would argue, it is easier for everyone to overreact and be uncommonly worried about downside risk.