"All the information was always out there" - "Everywhere you look there are red flags"

My two recent posts expressed surprise, that organisations that should know better have called the Coronavirus outbreak a Black Swan Event. The first on March 29th and the second on March 30th.

When I wrote them, I had not seen an article written for an FT special report, Risk Management: Financial Institutions. The article by Robert Armstrong, the FT’s Chief Editorial Writer. It makes very interesting reading and prompts some important questions.

It quotes the head of risk management at a large US bank who did not wish to be named saying, “All the information was always out there, and until February 21, risk managers all over the world were just ignoring it.”

It also quotes from a blog by Scott Minerd, chief investment officer at Guggenheim Investments published on February 14th..He wrote: “The cognitive dissonance in the credit market is stunning . . . yields are low, spreads are tight, and risk assets are priced to perfection, but everywhere you look there are red flags.” The coronavirus, he notes, had been in the news since early January and looked more dangerous than Sars, its predecessor. “This will eventually end badly. I have never in my career seen anything as crazy as what’s going on right now.”

In A Theory of Cognitive Dissonance (1957), Leon Festinger proposed that humans find coping with contradictory ideas or experiences stressful leading them to blindly believe whatever they want to believe to reduce the cognitive dissonance. It also results in the avoidance of circumstances and contradictory information likely to increase the magnitude of the cognitive dissonance. It is related to what Margaret Heffernan calls Wilful Blindness. This is also a legal term to describe a situation in which a person seeks to avoid civil or criminal liability for a wrongful act by intentionally keeping himself or herself unaware of facts that would render him or her liable or implicated.

Here we have a situation in which market conditions prior to the crisis seem to have been creating a false sense of security even though there were red flags everywhere, one being the risk of a pandemic. This seems likely to have been the produced by cognitive dissonance leading to wilful blindness.

Now recognise that this description of the situation does not only affect those in the financial markets. It applies to all humans whatever their occupations, including policy makers, politicians and all kinds of professionals in all professions and all sectors of the economy. The point I am making is that it does not only explain why the markets were slow to respond.

But the bigger questions are event if they had responded earlier, would the responses have been any different, and would it have made any difference to the levels of preparedness for dealing with the problem. The answer is yes and no. Any extra time would have saved lives. But preparedness means far more than that.

For the markets it means “Have a plan in place before an event occurs.” Because having decided in advance how to respond to a range of scenarios helps avoid getting caught up in emotion as an event unfolds, allowing traders to “focus on the facts” rather than market sentiment as Max Gokhman, head of Asset Allocation at Pacific Life Fund Advisors suggests. But, as the article the second of my two posts makes clear, that will only be of any use if cognitive dissonance does not get in the way of the plan being implemented. 

For the markets risk management may simply mean spotting signals early enough to sell before a crash. For everyone else if means preventing a crisis if possible, and acting early enough to minimise the impact of one if prevention is not possible. And in all cases it means avoiding the risks of cognitive dissonance and other mental weaknesses that are common traps for decision makers. Only then can we avoid Predictable Surprises.

These issues will be explored in detail as the Strategic Management Forum begins a year-long "Inquiry into the nature and causes of predictable surprises", beginning soon. For details: [email protected].