The recent colossal explosion on Wall Street amongst Archegos Capital and some of the world’s largest and most prestigious investment banks resulted in the loss of many billions of dollars in a matter of a couple of days. Such a tremendous loss of wealth in a highly compressed period of time is undoubtedly an event worth examining and gleaning valuable lessons from. After decades of experience in the Hedge Fund industry, I am always interested in the cause of major events such as these. I’ve found that the cause is usually rooted in some form of identifiable cognitive behavior. In this case, multiple parties both caused and were impacted by the event directly and indirectly. On one side, there is Bill Hwang, whom I know to be a seasoned investor, having come from my old firm, Tiger Management, and therefore having learned from the best hedge fund portfolio manager of all time, Julian Robertson. Then there are the big banks who have the best of the best looking after their risk management. The downstream effects by the shareholders of all the public companies involved and the new regulations that will result from this event are those who were and will be indirectly, but meaningfully, impacted.
The question that seems prevalent to all sides is: How could they not see this coming?
The answer, in my opinion, lies in the neuroscience of cognitive biases, also known as blind spots. This particular instance was like driving down the highway, pulling into your right lane, and getting nailed by a giant Mack Truck because you did not see it in your rearview mirror. It was in just the right spot, or more accurately just the wrong spot, the blind spot, and then WHAM!
How could this happen?
Archegos was able to put on immense leverage (i.e., borrowing) with several lenders/banks by using derivative exposure via total return swaps. Utilizing derivative instruments to put on exposure avoids the very “public” transparency of loans being drawn down and shares being bought directly by Archegos. The current regulatory regime is such that disclosures for swap exposure to the underlying securities are not treated the same way as directly holding the securities themselves. As such, the individual banks apparently did not know the extent to which Archegos was exposed to Viacom, Discovery Inc., etc. They only knew the exposure Archegos had on their books, not what the other counterparties were exposed to. This lack of transparency presented a very literal blind spot. If Archegos’ counterparties all needed to sell the same collateral at approximately the same time to meet margin calls, the greater the volume sold, the greater the impairment of collateral. This resulted in a death spiral of value swiftly sliding down the drain. This also left some of the banks that were slow to react holding the proverbial “bag.”
Further, since Archegos’ is a family office, as opposed to a regulated fund, there were even fewer disclosures and protections required than for a fund that is open to investors. Absent also was the due diligence process that investors perform on hedge funds prior to investing. This additional layer of due diligence is often a rigorous process that can reveal many shortcomings of a fund’s risk management safeguards, amongst other internal controls. The blinders are off now; there are and will be many eyes on this from the regulators and banks to prevent it from happening again. The parties will also seek to stem any further downstream damage from this particular event.
Cognitive bias in the investment world is the phenomenon of irrational behavior that ultimately leads to poor decisions. When these decisions are levered up, they can lead to losses of magnitude, and in this case, losses of enormous magnitude. Cognitive biases have been pre-programmed into our DNA for the purpose of allowing us to make quick decisions based on limited information – for survival. Delay could mean that we would be eaten by a predator. However, that is not the environment we are in today – at least not in the investment world. Quick decisions based on our instinctual wiring, as opposed to being based upon reasoned, logical thinking, can lead to devastating losses. There are various cognitive biases at play in the investment world, and it is a challenge to figure out which are present in any given situation. However, it is a worthwhile practice to become aware of them and have a plan to mitigate or eliminate their negative impact on our decision-making when they arise. There are many cognitive biases, but here are just a few that could have played a role in the Archegos situation. These biases could have been present for the Archegos team and/or the banks that leveraged them. When reading these, consider the decisions that each of the parties needed to make and how these biases could have impacted them. Here are a few to get you started:
Archegos: How much to buy? How much to borrow?
Brokers: How much to lend? When to sell collateral?
Overconfidence is a bias that occurs when investors erroneously overestimate their ability to make predictions based on currently available information. Overconfidence comes from believing that your successes are primarily due to your skills, whereas any failures are merely due to, well, bad luck! Those with an overconfidence bias underestimate the risks involved in any given investment decision. This belief causes the decision-maker to falsely conclude that no further work is necessary before making the investment decision.
Incentive bias occurs when the sought-after reward’s overall objectives are not aligning with the incentives, resulting in poor decision-making. The sub-prime housing crisis was a prime example of this. Various parties were making money in a seemingly effortless fashion. Banks were lending massive amounts of money to those with terrible credit risk. Why? Doing so was laden with incentives all along the chain from the brokers, developers, banks, and finally to the credit agencies.
Buffett said: “Nothing sedates rationality like large doses of effortless money. After a heady experience of that kind, normally sensible people drift into behavior akin to that of Cinderella at the ball …. the giddy participants all plan to leave just seconds before midnight. There’s a problem, though: They are dancing in a room in which the clocks have no hands.”
Restraint bias is the miscalculation of one’s ability to resist temptation. Our survival instincts have wired people to be greedy. If an investor sees a sure winner, there will be a tendency to oversize it – perhaps by borrowing or lending.
The bandwagon effect is the bias of taking comfort in an investment simply because others have invested. Is it possible in our example that once two or three brokers provided the financing to Archegos, the others followed along? Somebody did the KYC due diligence, right? The bandwagon effect is also closely related to confirmation bias. This occurs when an investor looks only for evidence supporting their hypothesis and ignores information that is contrary to their predetermined conclusion.
Sunk Cost Bias
The “sunk cost” bias keeps one from selling a bad investment (or collateral for a bad loan) for the sole reason that there was money already sunk into the investment. This is not a rational decision! The investor is emotionally invested, not rationally! The fact that money has already been spent/lent has nothing to do with whether the investment should continue to be held. Only the future prospects of that investment weighed against the opportunity cost of deploying that capital in other more potentially profitable investments should be considered. In other words, selling the loser and deploying the capital in a better investment would be the logical decision.
Greed and Fear – the Underlying Culprits
When cognitive biases lead to irrational decision-making in the investment world, the emotions of greed and fear are usually lurking in the background. This often translates into taking too much, or too little, risk. There is absolutely nothing wrong with the desire to make money. There is typically a line that needs to be crossed to get it to the level of greed, and it is on the other side of this boundary where undue risks reside. There is a saying in the investment world: “pigs get fed; hogs get slaughtered.” Fear can be just the opposite – not taking enough risk can also “opportunity” cost you.
Greed. Greed is merely just “desire” on steroids. Desire is biologically wired into our DNA and serves a strong purpose for our survival. Borrowing money is essentially free now with interest rates so low. There is a huge temptation to do so and to use it to juice up returns. Leverage magnifies whatever the investment return is – positive or negative – and that is the point. Nobody complains when it works out, but when it does not, look out for a world of hurt in a massive and expeditious manner. Also, in this low return environment, fees are at a premium. The temptation to take more risk to earn fees is undoubtedly a factor that needs to be observed in any risk management analysis.
Fear. It is hard to tell where, or if, this emotion potentially reared its head in the Archegos saga. Fear is also biologically wired into our DNA to help us. When we spot danger, our sympathetic nervous system kicks in. This is commonly referred to as the fight or flight response. The signal from our nervous system is to prevent harm by preparing to fight OR by fleeing (i.e., flight) from danger. Goldman, Morgan, and Deutsche apparently fled quickly! They sold out and spared themselves. A lesser-known reaction to fear can also be to pause or freeze before reacting. From the news reports, this was the course of action, or more accurately lack of action, that Nomura and Credit Swiss pursued. They did not unwind on time, and apparently it cost them.
What to do?
The most important thing you can do to combat the phenomenon of behavioral bias is first to have the awareness that it exists. Knowing the different types of cognitive biases can help you spot when you are becoming ‘under the influence.’ Remind yourself that these biases lead you to suboptimal decisions that are not in your best interests or the best interests of your firm. If the emotions of fear or the temptations of pushing the envelope arise (a nice way of saying ‘greed’), be on guard that a cognitive bias is lurking around the corner to lead you astray in your decision-making. The instincts of fear and greed originate in the depths of the oldest area of our brain, the amygdala. Fortunately, the newest area of the brain, the prefrontal cortex, can override the initial instincts of fear and greed. Unfortunately, unless we have the training to do this (mindfulness), the instincts will win out, resulting in poor decisions. This is not only present in high finance but in every area of our businesses, careers, and personal lives.
Prevention – Set Yourself Up for Success
The key to being able to override these emotions, and the cognitive biases that they express themselves through, is to design prevention techniques that set you up for success in advance. Once you are in the throes of emotion, it is often too late. Turn over as much decision-making in advance to technology. Why? Technology is immune to the behavioral bias tricks of the mind! Also, put processes and procedures in place that take the decision out of your hands in advance while you and/or your team are not yet under the spell of emotions that can lead you to illogical decisions. Stop loss and position limit processes are examples of decisions being made in advance via both process and technology to bypass the human mind’s emotional reactions, thus thwarting the negative implications of cognitive biases.
Decision Making Leverage – Technology and Process
At my new firm, where we coach executives and consult businesses in the investment industry, a primary focus is to understand the neuroscience behind decision making. We are obsessed with uncovering ways to hack the best parts of our neurology and override those areas that no longer serve us. We have developed a sophisticated decision-making software platform to process all important decisions – both investment and non-investment-related. This platform is a combination of technology and process. It has been designed to pull as much emotion out of any decision as possible and add the highest quality facts – since decisions are only as good as the inputs and processes used in making them. In doing so, we can be sure that our decisions are made as purely as possible, based on logic and free of emotion and cognitive bias. A predetermined series of weighted criteria is the basis of each decision. A score is generated for each option of the decision tree. The highest scored option wins, not the one with the highest emotional attachment.
The bottom line
Decisions that are born out of emotion often have the imprint of a cognitive bias attached. Cognitively biased decisions are skewed towards the irrational. Be sure to understand the different types of cognitive biases. Have a plan in advance for each one before emotions arise that trigger your cognitive biases. Use technology and processes that set yourself up for logical and emotion-free decision-making. Feed the PIG – don’t get slaughtered!