Markets don't care about your feelings

We are often reminded that having a positive attitude achieves better results. Scores of books have been written extolling optimism, going back to 1952's The Power of Positive Thinking by Norman Vincent Peale. Generally speaking, expecting positive outcomes has a beneficial psychological effect. We are happier when we experience positive thoughts. However, problems occur when those positive thoughts lead to dismissing evidence that says those thoughts aren't in line with reality.

Optimism bias is the tendency to think that we are above average and that it's unlikely we will get sick, have a traffic accident, or make poor investments. These are things that happen to "other people." It is usual for humans to overestimate their achievements and capabilities in relation to others. But in the real world, we can't all be above average, and bad things can happen to any of us.

Optimism Bias Effect on Risk Management:

• Undue Confidence. Optimism bias can cause undue confidence that “things will work out."  This irrational confidence can result in forgoing a good risk management strategy.
• Cut Corners. Optimism bias can cause risk managers to cut corners and leave a company dangerously exposed.
• Unrealistic Behaviors. Optimism bias can result in unrealistic expectations for  how quickly a project can be completed, so the risk management plan may not have a sufficient duration (this variety of optimism bias is referred to as planning fallacy bias).

Optimism Bias, SBF, and the Downfall of FTX:

The recent implosion of FTX is an example of optimism bias.  FTX's CEO was Sam Bankman-Fried (SBF), a 30-year-old who was described in the media as the “next Warren Buffet."

Alameda was a trading company run by SBF's former girlfriend, Caroline Ellison. They borrowed funds from FTX for use as margin to support speculative trading in crypto. When the crypto market collapsed they had big losses, so they couldn't repay the loan from FTX. By some accounts, it led to an $8 billion loss for FTX. How could this have happened?

1. SBF did not foresee the potential for a collapse in the crypto market. Between June and November 2022, crypto prices (as measured by the CIX index) dropped over 75%. It’s possible that SBF believed that the market would rebound, just as it had from every dip for the previous several years. His optimism may have blinded him from seeing conditions had changed (primarily the concerted interest rate increases by global central banks and losses in all classes of risk assets.)
2. SBF knew (maybe too well) the players at Alameda. Alameda’s CEO, Caroline Ellison, was SBF's former girlfriend and colleague at a prior business.  He placed too much trust in her and her team, which led to insufficient oversight. In an interview with CNBC, SBF said, “Look, I wasn’t running Alameda. I didn’t know exactly what was going on. I didn’t know the size of their position.”  As FTX CEO, he should have known what was going on.  Was his optimism the reason he didn’t pay close attention?
3. SBF thought he could “save” the crypto market from collapse. In the summer of 2022, he purchased crypto lender BlockFi and was described as the “J.P. Morgan of crypto,” referring to Morgan’s backstopping the American banking system during the Panic of 1907. Again, his optimism kept him from seeing the apparent downward spiral of crypto assets.
4. FTX didn’t bother to maintain standard management protocols for a company of its size ($32 billion). They didn’t have a Chief Risk Officer, and according to John Ray (the man appointed to oversee bankruptcy proceedings), they were using Quickbooks to do their accounting. Was this because SBF believed that “it would all work out” and the norms were unnecessary?

Takeaways:

• Currency markets are not as volatile as crypto, but the moves are significant, and being on the wrong side can decimate a company’s profits. Every company with FX risk should have a plan to protect themselves. That means a plan based on realistic analysis and projections, not a hope that everything will work out in the end.
• Recognize that biases (including optimism bias) exist in all human beings. That’s why it’s critical to have a system of risk management that is not reliant on just one person or one team’s expectations. It’s best to have an objective third party assist in risk analysis, just like a company uses an outside auditor to certify its financial statements.
• Risk management should be as objective as possible, minimizing the potential for bias to influence decision-making. While markets may not care about our feelings and wishful sentiments, at Pangea, we believe that they are human inventions. Not inevitable forces. This is why we developed Pangea Prime, an AI system that hedges risk on FX.

Pangea's AI monitors currency markets 24 hours a day, seven days a week, and operates at the speed of market sessions. The AI uses decades of data to analyze how currencies may impact your P&L and executes hedges automatically, so you don't have to worry about human bias or negligence. 

Schedule a demo today to learn how Pangea Prime can help you focus on growing your business instead of spending your time, energy, and resources trying to manage FX risk.