The Illusion of Certainty & Search for Clarity - II

Dear Clients,

This article is an extension of the previous one. In the previous article I laid my thoughts on 3 things.

Neat: How things look neat, in a presentation, or an analyst report or in any written / verbal communication. The reality is much more volatile and uncertain than what is anticipated.

Illusion of Certainty: I also touched upon the “Certainty” bias i.e. how we feel certain once the event has already happened and based on that false sense of certainty, we may make decisions which may not come out in our favor in the future. Today for everyone (including myself) Reliance Industries was a screaming buy at Rs. 800 - Rs. 900. But that sense of certainty comes “after” Reliance reached Rs. 2000.

Odds: Finally, I discussed how can we think in terms of “Odds” because certainty is an Illusion. I would like to propose a framework here. This framework has been used numerous times with appropriate alterations (known as the Johari Framework) and hence there is nothing new about it. But I liked the framework and thought to share it with all of you.

 

Can cause mild corrections	Known – Knowns (Risks we are aware and can predict)	Known – Unknowns (Risks we are aware but cannot predict)	Can cause corrections but not crashes
Can cause big crashes	Unknown – Knowns (Risks we can predict but are not aware)	Unknown – Unknowns (Risks we are neither aware nor we can predict)	Can cause biggest crashes

 

 

 

 

 

 

 

Let us look at each of the quadrants one by one and use Covid-19 as our topic for Analysis.

Unknown – Unknowns: These situations create the biggest crashes because the risk associated with that particular “event” is neither known and nor we can predict. This is where we were in the first quarter of calendar year 2020 (especially March 2020). Covid-19 was not known to impact in the way it did, and the market was not able to predict and hence the crash. Typically, we call them “Black Swan” events. They hit the markets out of the blue and the corrections are swift and deep.

Known – Knowns: These situations cause mild corrections which is the usual nature of the market. Currently Covid-19 is in this quadrant. We know what it is and was kind of impact it can have on the economies. The lockdowns, the decrease in sales, job losses, lack of hospital beds, etc. I feel for the foreseeable future, every now and then media will keep focusing on of the issues mentioned above like the temporary lockdowns, job losses due to Covid-19, etc. But from the market perspective this event has come from the Unknown – Unknown quadrant to the Known – Known quadrant.

Known – Unknowns: These situations can cause corrections but not crashes. Here we know the risks of the event as it has occurred and first order effects has already played out, but not sure about the second order effects. Again, taking the Covid-19 example we are aware about the risks associated with NPA in the banking sector. But we do not know yet what will be the results once the 90-day period after moratorium (moratorium ended in August 2020) ends. So, if the results from the banking sector are going to be as expected or better, than the market’s move in banking stocks will continue it’s upward trajectory and if at all the results are going to be worse than expectations, we can see  correction in the banking sector which can spill to the broader markets.

Unknown – Knowns: These situations can cause crashes in the market. Not as big as Unknown – Unknowns but still deep enough. Here we can predict the risks associated with certain events but not sure when these events will occur. Nuclear war, abrupt downfall of a stable government, 9/11 type of terrorist attacks, etc. fall under this category.

As far as the Covid-19 situation is concerned, markets have come from bottom – right quadrant of Unknown – Unknowns (the ones that can cause the biggest crash) to the top – left quadrant of Known - Knowns (the ones that can cause mild corrections). The problem with us is, we are psychologically still in the bottom – right quadrant of Unknown – Unknowns. We still feel that a GDP growth rate of -10% instead of -8% will bring a deep correction or crash in the market. No, it will not. All those things have been factored in March of 2020. We still feel that number of daily cases from “x” to “x+1” will crash the markets. No, it will not. As I have eluded earlier, lockdowns, lack of hospital beds, joblessness, negative gdp growth numbers, in other words everything negative that we read in the newspaper relating to Covid-19 will not crash the markets now. Because now it comes under the top – left quadrant.

In the movie “Andha Kanoon” Amitabh Bachchan kills Amrish Puri in the court and tells the judge – “Aap mujhe is katal ki saza nahi de sakte kyun ki iski saza mein kaat chuka hoon. Koi kanoon insaan ko ek hi gunaah ki do baar saza nahi de sakta”. Because we are psychologically in the bottom – right quadrant we are still reeling under the news related to Covid-19. For markets the first order effects of Covid-19 are history. It is looking for second order effects which we won’t be able to find it in the media, any media. We will have to figure that out ourselves.

I believe the above framework is very helpful to understand where we are currently and what risks the current environment poses relative to a particular event. This can also help us to keep the noise away. This can help us to look at the odds of our hypothesis in a much more structured way.

 

Regards,

Nishith Vyas