“When there's uncertainty, we shouldn't be looking for certain outcomes,” according to Tom Matthews, co-manager of the JOHCM UK Dynamic fund, who has warned that investors are too focused on binary scenarios rather than embracing the grey area.
It is not necessarily their fault, however. He noted there are two key parts of the brain that are used for decision-making that lead to very different reactions.
The prefrontal cortex (or ‘wizard brain’) is the large part of the brain at the front that handles deep reasoning and probabilistic thinking. This is where most people make a lot of their decisions from.
However, during times of stress, the driving force for our actions changes to the amygdala, which he referred to as the ‘lizard brain’.
The amygdala is often used most when there is an overlap of crises, which “generate a strain on human comprehension that exceeds our ability to anticipate future developments”, said Matthews, referencing work done by the Cascade Institute.
“Put another way, it's cognitive overload,” he said.
This is a result of evolution. When attacked by a wild beast, for example, it was in our best interests to move away from the prefrontal cortex and instead use the amygdala, which moves much quicker but tends to view the world in binary black-and-white outcomes. Another name for it is 'fight or flight'.
“That's great for hunting, but terrible for markets and terrible for investors,” said Matthews.
Instead, investors should take a lesson from Annie Duke, the World Series of Poker champion and cognitive behavioural scientist. She is also the author of Thinking in Bets, a book the JOHCM UK Dynamic fund manager said is extremely popular “in investing circles”.
“She has a quote in her book: ‘Black-and-white thinking, uncoloured by the reality of uncertainty, is a driver both of motivated reasoning and self-serving bias’,” he said.
These binary outcomes are everywhere, he noted. For example, in recent years markets have been obsessed with central banks and whether they would achieve a hard or soft landing when it came to taming inflation.
More recently, it has been whether a company is an AI winner or loser – a fixation that led to this year’s ‘SaaSpocalypse’. In healthcare there is a similar movement between the winners of the GLP-1 weight loss and diabetes drug craze and those companies not involved in this particular market.
“The market is obsessed with these black-and-white outcomes. Why? Because the market keeps trying to sell you certainty,” said Matthews.
These are far from the only binary outcomes being backed by the market. He used the example of hedging.
“I went to our Bank of America broker and asked him for his baskets. They had a menu of European baskets. Just on the custom baskets he uses for hedging, he had 43 available,” the JOHCM manager said.
By contrast, Matthews only holds 38 stocks in his entire JOHCM UK Dynamic portfolio. “So that gives you an idea of the sheer volume of trades buffeting the market right now,” he said.
However, during times of uncertainty, investors should not be looking for certain outcomes but instead should consider the world in probabilities,
He said: “We need to be introducing uncertainty into our analysis. What is the likelihood of that outcome? What are the alternative truths? What else could happen that isn't in that binary spectrum? And what does the valuation imply?
“As investors, we shouldn't be buying narratives. We should be buying outcomes, the probabilities. So be very wary of these pervasive narratives, because they are genuinely distorting reality.”
He argued this is clearest in the UK. For more than a decade, investors have largely ignored the domestic market in favour of the US, where returns have far outpaced UK equities.
As a result, the UK market has been overlooked and stocks are now on “multi-decade discounts” to their overseas peers. Overall, the UK market sits at a 25% discount to the US based on sector-adjusted price-to-earnings ratios.
“UK equities are the Costco of global equities right now. Costco's business model is all about offering globally recognised brands at a discount, in bulk. Sound familiar? That's exactly what we've got in the UK right now,” said Matthews.
This, however, overlooks the fact that UK equities have compounded at a 10.8% rate over the past five years, only just behind the 13.2% from the MSCI AC World. Without technology (an area the UK historically has lagged in), that figure plummets to 9.7%.
It is an example of a behavioural bias and black-and-white thinking in action. However, he is not disappointed. In fact, Matthews said he likes behavioural biases.
“Behavioural biases mean market inefficiencies and that's what we're starting to see in the markets at the moment, which is why we're very excited,” he concluded.