By now, every executive in business recognises the term “Black Swans” as representing 
low probability, high impact events. However, many do not know how to handle them in ther management of risk. There is an HBR article by Taleb, Goldstein and Spitznagel discusses the 6 most common mistakes made by executives in this regard. Summarising the article ….
- We think we can manage risk by predicting extreme events.
The advice is NOT to try and predict these Black Swan events (which by definition is impossible), but rather try and identify your vulnerabilities and focus on the consequences of these events and how to withstand them. What my colleagues in Consileo call “building resilience”. - We think by studying the past we will be better able to manage risk.
You cannot use hindsight as foresight as paste events do not bear much resemblance to future shocks. I do not think the article is saying that nothing can be learned from the past; but rather that Black Swan events cannot be predicted using past trends and happenings. - We don’t listen to advice about what we shouldn’t do.
We tend to like positive advice far more than negative (loss prevention) advice and so give greater weight to the positive advice. A dollar not lost is economically equivalent to a dollar earned, but risk managers don’t treat them equally. - We assume that business risk can be measured by standard deviation.
Although statistical techniques are useful in concepts like investment risk, they are dangerous in real life where events do not follow a normal distribution. The article also claims that even many quants analysts do not really understand the concept of standard deviation and so what is the chance that non-experts are going to get it right. - We don’t appreciate that what’s mathematically equivalent isn’t psychologically so.
Here the authors demonstrate that how the same risk is presented can significantly impact on how we react to it. They are basically discussing the concept of framing and our heuristic-driven response to different descriptions of the same thing. - We are taught that efficiency and maximising shareholder value don’t tolerate redundancy.
Basically here the paper highlights how too much optimisation can increase an organisation’s vulnerability. To demonstrate this, a “lean” human being would only have one lung and one kidney!
The article ends discussing the risk of incentivisation if structured incorrectly. I really like their conclusion here which is so appropriate in light of the financial-system driven crash we are trying to recover from; and even the news of the last week where JP Morgan have announced a $2bn trading loss (which I suspect may only be part of the true picture, but we will see …):
“Moreover, we shouldn’t offer bonuses to those who manage risky establishments such as nuclear plants and banks. The chances are that they will cut corners in order to maximise profits.”
The full article may be found at the Harvard Business Review web-site at
The 6 mistakes article
although you may have to register to download it
A while ago we wrote an article called: Taking strategic decisions in the face of “unknown unknowns” which complements this risk article nicely and gives some advice about what you could actually do to address some of the challenges put forward by Taleb.
Decisions in the face of uncertainty
If you would like to discuss how we may assist you and your organisation in addressing critical risks and building resilience, please drop me a line at sgifford@genesis-esp.com
