Why Did So Many Investors Ignore Warnings Before the Crash of 2021?

This Pre-Mortem was recently published by our affiliate, The Index Investor, which provides global macro research and asset allocation insights.

Tesla. Bitcoin. GameStop. The equity market as a whole. Even the bond markets. The list goes on. Why did so many investors ignore so many warning signs that were flashing red before the Crash of 2021? And more importantly, what was different about investors who did not ignore those warnings?

As always, there were many root causes that amplified each other’s effects.

Let’s start at the individual level.

Tali Sharot’s research has shown how humans have a natural bias towards optimism. We are much more prone to updating our beliefs when a new piece of information is positive (i.e., better than expected in light of our goals) rather than negative (“How Unrealistic Optimism is Maintained in the Face of Reality”).

Individuals seek more information about possible future gains than about possible losses (e.g., “Valuation Of Knowledge And Ignorance In Mesolimbic Reward Circuitry”, by Charpentier et al).

We tend to seek, pay more attention to, and place more weight on information that supports our current beliefs than information that is inconsistent with or contradicts them (known as the confirmation or my-side bias). Moreover, as Daniel Kahneman showed in his book, “Thinking Fast and Slow” this process often happens automatically (“System 1”). When we notice information that is not consistent with our mental model/current set of beliefs about the world, our subconscious first tries to adjust those beliefs to accommodate the new information.

Only when the required adjustment is above a certain threshold, the feeling of surprise is triggered, calling on us to consciously reason about its meaning using “System 2”.

Yet even then, this reasoning is often overpowered by group-level factors.

Having spent so much of our evolutionary existence in a world without writing or math, humans naturally create and share stories rather than formal models to make sense of our uncertain world. Stories are powerful because they have both rational and emotional content; while that makes them easy to remember, it also makes them very resistant to change.

Another group level phenomenon that is deeply rooted in our evolutionary past is competition for status within our group. Researchers have found that when the result of a decision will be private (not observed by others), we tend to be risk averse. But when the result will be observed, we tend to be risk seeking (e.g., “Interdependent Utilities: How Social Ranking Affects Choice Behavior”, by Bault et al).

Other research has found that when we are engaged in social status competition, we actually have less working memory available for reasoning about the task at hand (e.g., “Increases in Brain Activity During Social Competition Predict Decreases in Working Memory Performance and Later Recall” by DiMenichi and Tricomi).

Another evolutionary instinct comes into play when uncertainty is high. Under these conditions, we are much more likely to rely on social learning and copying the behavior of other group members, and to put less emphasis on private information that is inconsistent with or contradicts the group’s dominant view. The evolutionary basis for this heightened conformity is clear – you don’t want to be cast out of your group when uncertainty is high.

It is also the case that groups will often share more than one story or belief at the same time. Research has found that, “as a result of interdependent diffusion, worldviews will emerge that are unconstrained by external truth, and polarization will develop in homogenous populations” (e.g., “Interdependent Diffusion: The Social Contagion Of Interacting Beliefs” by James P. Houghton).

All of these group causes have been supercharged in our age of hyperconnectivity, dense social networks, and multiple media platforms constantly delivering a flood of information.

Finally, individual and group causes are often reinforced by organizational level phenomena.

As successful organizations grow larger, there is a tendency to recruit and promote people who have similar views. Growth also tends to increase the emphasis an organization places on predictable results, which causes them to penalize errors of commission (e.g., false alarms) more heavily than errors of omission (e.g., missed alarms).

Thus employees in larger organizations are very likely to wait longer and require strong evidence before speaking up to warn that danger lies ahead.

In his January 2021 letter to investors (“Waiting for the Last Dance”), GMO’s Jeremy Grantham explained why larger organizations are less likely to warn clients when markets are severely overvalued:

“The combination of timing uncertainty and rapidly accelerating regret on the part of clients [for missing out on gains as the bubble inflates] means that the career and business risk of fighting bubbles is too great for large commercial enterprises…

“Their best policy is clear and simple: always be extremely bullish. It is good for business and intellectually undemanding. It is appealing to most investors who much prefer optimism to realistic appraisal, as witnessed so vividly with COVID. And when it all ends, you will as a persistent bull have overwhelming company. This is why you have always had bullish advice in bubbles and always will."

In sum, that so many suffered large losses when the post-COVID bubble burst should come as no surprise. It was merely the latest version of a plot line that has been repeated for centuries in speculative markets.

The real lessons to be learned come from those investors who reduced their exposure and changed their asset allocations before markets suddenly and violently reversed (analysts are still searching – likely in vain -- for the cause of the market crash. Such is the nature of complex adaptive systems).

What did these investors do differently?

We know one thing they didn’t do – believe that they could personally overcome the very human and deeply rooted evolutionary biases noted above. Research says that odds against success in that endeavor are long indeed.

Rather than trying to conquer their personal biases, these investors established – and followed – investment processes that were designed to offset those biases and their emotionally charged effects.

For example, they didn’t fall prey to the “this time is different” myth, and used traditional valuation metrics to inform their asset allocation decisions. Their default conclusion was that the valuation metrics were right, and demanded very solid, logical and evidence based arguments to reject the signals they sent.

In their own forecasting, they followed best practices. They spent a lot of time making sure they were asking the right questions; they paid attention to base rates; they were disciplined about seeking out high value information to update their views; and they were always alert to surprises that warned their beliefs and models were incomplete.

They also sought out forecasts from a wide range of other sources that were based on different information and/or methodologies, and then combined them to increase their predictive accuracy.

And they focused their forecasting efforts on time horizons beyond the range of the algorithms, where human effort can still produce a profitable edge.

Most important, perhaps, is this timeless truth: The investors who avoided the Crash of 2021 weren’t any smarter than those who were wiped out. They were just more conscious of their own weaknesses, and as a result their investment processes took a more disciplined approach.

The Fall of the US Capitol: All Three Causes of Strategic Risk Failure Were at Work

The fall of the US Capitol building to a mob of rioters on January 6, 2021 left millions stunned and horrified, and all asking the same question: "How Could This Happen?" Unfortunately, the answer is painfully familiar to those of us who study strategic failure and spend our days helping organizations to avoid it. The initial evidence suggests that all three of the most common root causes of such failures were present in this case too.

The first root cause is failure to anticipate potential future strategic risks, and to recognize them as they begin to emerge.

It is critical to distinguish between three levels of anticipation and warning.

t the strategic level, analysts focus on the "what" and "why" of potential threats. At the operational level, they focus on "how' different threat might materialize. At the tactical level, the focus is on the"who, what, and when" that drive effective response.

The fundamental challenge of threat anticipation and warning is that the possibilities increase exponentially as you move from the strategic to the operational and then to the tactical level.

During April and May 2020, protests against continuing COVID lockdowns erupted across the United States. Many of these were instigated and/or backed by groups on the populist right.

Following the death of George Floyd on May 25, 2020 in the course of his arrest, protest demonstrations were held across the country, with many instigated and/or backed by groups from the populist left. A significant number of these degenerated into rioting.

In September, a draft Department of Homeland Security assessment appeared in the press, which named white supremacist groups as the most dangerous terror threat facing the United States.

On October 8, 2020, the FBI announced the arrest of members of a right wing group who were conspiring to kidnap Michigan Governor Gretchen Whitmer due to anger over lockdowns and other alleged abuses of state government power.

In sum, the growing strategic threat of violent protests by both left and right wing groups was clear.

Operationally, it is certain that the Capitol Police and other intelligence and law enforcement agencies had anticipated the threat posed by a terrorist attack that sought to gain control of the building and harm legislators and staff within it. It is equally certain that they had in place and had frequently rehearsed plans to violently repel a violent attack.

It also is also certain that plans were in place to respond to demonstrations with a high assessed potential to become violent. However, it is not clear that there were operational plans to respond to a demonstration that evolved into an attempt to takeover the capital without the use of weapons and violence, as would be the case in a terrorist attack.

There is accumulating evidence that the Capitol Police had tactical (albeit noisy) warning that the demonstrations planned for January 6th had a significant potential to become violent.

For example, ProPublica reported that, "Capitol Rioters Planned for Weeks in Plain Sight. The Police Weren’t Ready. Insurrectionists made no effort to hide their intentions." Like a growing number of similar reports, this one highlights the amount of detailed information that was available online about plans by some groups to attempt to disrupt the certification of the Electoral College results on January 6th. As ProPublica notes, "The warnings of Wednesday’s assault on the Capitol were everywhere — perhaps not entirely specific about the planned time and exact location of an assault on the Capitol, but enough to clue in law enforcement about the potential for civil unrest."

Similarly, the BBC reported that, "In the days (and indeed weeks and months) before the attack, people monitoring online platforms used by extreme pro-Trump supporters and far-right groups had warned of rhetoric encouraging violence at the Capitol, including toward lawmakers, over the election result. Some were even pictured wearing clothing that said "MAGA: CIVIL WAR" printed alongside the 6 January 2021 date."

ABC News provided more specific information, reporting that, "Three days before supporters of President Donald Trump rioted at the Capitol, the Pentagon asked the US Capitol Police if it needed National Guard manpower."

The second root cause is failure to appropriately and accurately assess the nature, timing, and danger posed by an identified threat.

One clear assessment failure was the apparently very low probability given to a scenario in which people protesting the Electoral College result would attempt to takeover the Capitol building and harm the Vice President and legislators meeting there on January 6th. As the ABC report noted, Capitol Police were only preparing for a "free speech demonstration" of which there are many at the Capitol during the course of any year.

Considering that the last time the security of the Capitol was violently breached was in 1954 (when Puerto Rican terrorists shot down from the visitors gallery on members of the House of Representatives), the Capitol Police's threat assessment failure is depressingly common.

As Thomas Schelling famously noted, “There is a tendency in our planning to confuse the unfamiliar with the improbable. The contingency we have not considered seriously looks strange; what looks strange is thought improbable; what is improbable need not be considered seriously.”

Similarly, a 1983 CIA study found that, "In the [intelligence] estimates that failed, there were a number of recurrent common factors which, in retrospect, seem critical to the quality of the analysis. The most distinguishing characteristics of the failed estimates...was that each involved historical discontinuity and, in the early stages, apparently unlikely outcomes. The basic problem in each estimate was to recognize qualitative change and to deal with situations in which trend continuity and precedent were of marginal, if not counterproductive, value.”

The third root cause is a failure to adapt in time to a developing threat.

Another classic cause of strategic failure is a poor grasp of the interacting and usually non-linear time dynamics that are at work. Specifically, organizations typically overestimate the time that remains before a developing threat passes a critical threshold, while also overestimating how quickly they can develop and implement an effective response to it. In short, their remaining "safety margin" is often smaller and shrinking more quickly than they realize.

The available evidence suggests this source of failure almost certainly contributed to the fall of the Capitol on January 6th. For example, the AP reported that, "As the mob descended on the building Wednesday, Justice Department leaders reached out to offer up FBI agents. The [Capitol] police turned them down." While some of this may have been due to inter organizational rivalry and a desire on the part of the Capitol Police to avoid embarrassment, it is almost certain that if Capitol Police commanders had an accurate awareness situation's time dynamics, they would have accepted this offer of aid.

Nor were preparations in place to coordinate and control rapid adaptation if the demonstrations at the Capitol degenerated into rioting, as they did.

For example, Marketwatch reported that, "Army Secretary Ryan McCarthy said that as the rioting was underway, it became clear that the Capitol Police were overrun. But he said there was no contingency planning done in advance for what forces could do in case of a problem at the Capitol because Defense Department help was turned down."

No interagency command structure was established to coordinate tactical intelligence collection and fusion, and direct different agencies' response to the rapidly deteriorating situation at the Capitol.

In sum, while the actual events at the US Capitol on January 6th were unique, the underlying root cause of the strategic failure it represents were depressingly familiar.

Britten Coyne Partners advises clients how to establish methods, processes, structures, and systems that enable them to avoid strategic failures. Through our affiliate, The Strategic Risk Institute, we also provide online and in-person courses leading to a Certificate in Strategic Risk Governance and Management.