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Black Swans, Turkeys, Ostriches and other Christmas Poultry – a tale of Strategic Risk

Tuesday, November 30, 2010

A festive story about a quest to find the elusive black swans

As the global financial crisis (GFC) was starting to stabilise in Australia I talked to some of my peers to find out what was going through the minds of Australia’s prominent directors and what questions were coming up in their audit and risk committees. Thematically and consistently, directors at the big end of town were asking about black swans.

A black swan is a euphemism coined by Nicholas Taleb for a significant disruptive event that wasn’t foreseen at the time. The GFC was the most prominent example cited in the book.

Since the GFC there have been many significant disruptions causing material downgrades in company balance sheets and their earnings forecasts. And while many of these adjustments related to the GFC, many also did not.

Across the board adjustments to earnings forecasts were accompanied by a public statement that “no one could have reasonably foreseen these circumstances”. This always seemed to me to be an odd statement to make.

As I watched the value of my Australian shares plummet in some of these companies I wondered if this was because they don’t have good foresight capabilities? Some of these risks were highlighted in the top 10 risks by the World Economic Forum years ago, and indeed I’d been covering these on the speaking circuit for some time.

So clearly someone in these companies should have seen these coming. Or were they trying to use the plausible deniability defence? Cause for great concern. I have put a lot of stocks on my “avoid list” never to return as the “didn’t see it coming” excuse rings alarm bells. Very big ones. The good news is my portfolio is now skewed to companies who seek out black swans rather than those which blandly tell me that “stuff happens”. Well, as far as I know anyway.

What has happened to all the investment in risk management?

This situation does beg the question about all of this investment in risk management and whether there is an endemic problem in the way we try assess and manage risk. Indeed, prior to the GFC, the Australian Securities Exchange Corporate Governance Council was concerned that boards were swamped by process, being pulled into the minutia of things within business units and aggregation of data rather than having their most material business risks firmly understood and in focus.

It seems that in a post-GFC world, The Corporate Governance Council’s concerns were proved right. Many of these companies declared in their annual reports that they were in compliance with the updated version of Principle 7 (which requires management to brief the board on the material risks facing the organisation). But if there was compliance with this statement then the “reasonably foreseeable” defence (about not anticipating a change in conditions) should no longer be required, or indeed, available in most cases.

There is a huge disconnect between going through the motions and what Principle 7 declarations actually say and I’m surprised that there hasn’t been a class action in this area. Indeed, as I saw a lot of my retirement funds evaporate with the “didn’t see it coming” excuse, I was tempted to turn expert witness or launch a class action myself. Fortunately, a savvy class action lawyer from New York encouraged me to be part of the solution rather than amplifying the problem, so I’ve got back to my quest to find out more about black swans.

So let’s get back to black swans. Actually most of whom these are actually black (unforseen), as they’re usually a whitish-grey (reasonably foreseeable).

My journey to find the black swans, and what I found along the way.

Cast your mind back to late 2002. The American economy had bounced back from the September 11 attacks. In late 2001 US companies had used the attacks as an excuse to do write offs and lay off staff. Although the reasons for the write offs and layoffs had little to do with the attacks it was a convenient excuse to remove some of the padding in the balance sheet and set a new baseline. A new cycle of growth was starting and we were getting back to business as usual. Life was starting to look pretty good.

Around the time I was chatting with a colleague who was working in the United States. I’ll call him ‘The Futurist’ because he emphatically denies being one.

Our conversation at the time went a little like this.

Todd : What are you working on?

The Futurist: Community workshops on how to prepare for sub-prime.

Todd: What’s sub-prime?

The Futurist: Something, complexity, something, predatory lending at scale, something, systems effects, something, CDOs, something community resilience, something, economic meltdown, something, hitting the poorest hardest, people really need to pay attention, this will have systemic effects.

Todd: Fair enough. How’s that working out for you?

The Futurist: People tend to tune out and change the subject.

Todd: Uh huh, how’s your wife?

And hence, I found myself guilty of ostrich behaviour. I tuned out something I wasn’t able to process at the time and stuck my head in the sand. In the process, I ignored an important signal of an emerging change in the status quo. And of course, like most of us, this was not the first time I had done this.

Why a lot of what we do in risk management misses the point

This highlights the essence of what’s wrong with risk management, and why a lot of what we do in risk management misses the point.

Our risk assessment processes have an incredibly strong bias towards what we already know and have experienced in our lifetimes, rather than having a strong eye on the future.

And even worse, we have a bias towards what’s happened in recent memory, which are the often things which are already top of mind and being managed in some way outside a formal risk management system. As Al Gore said when he was last in town, “We have a habit of confusing the unprecedented with the unlikely”, which I suspect is also the point that Taleb was trying to make when he coined the “black swans” phrase.
Rob Kay pointed out in Risk Management Today (Issues 2 & 3, June–July 2010) that risk management is the business of dealing with uncertainty, but we often focus on things that are certain rather than those things that are fuzzy. This is of course where the black swans spend most of their time.

As part of my journey to go looking for black swans, I’ve spent much of the last few years trying to understand some of the models used by futurists (and people who deny they are futurists, but seem to be more insightful than futurists). I’ve explored systems theory, systemic risk, complex adaptive system, ecosystems resilience, systems limits and complexity theory. And all of a sudden, there they were — black swans as far as the eye could see.

I’m not sure I’d recommend the path I’ve taken to find these black swans. The dangers of immersing in systems thinking is that perverse things happen, like quitting your day job, getting wrapped up in community resilience projects, doing a permaculture course, ending up on the board of a conservation organisation or an environmental markets company and changing your views what to go long on. But I now understand why this work reminds me of a Douglas Adams character, Dirk Gently’s Holistic Detective Agency.

Other strange things happen as end up on a speaking tour in the United States to highlight “The seven things bigger than sub-prime” and all the three newspapers in the room report is “In Australia they have black swans.” Sigh, yes, I think all they heard was “something something, black swans, something something”. I think I now know how The Futurist feels.

Anyway enough about the journey. More importantly, what are these black swans, and where are they? And do you have great big gaps in your risk profile?

The problem with most risk assessment at the operational, financial and compliance level is that starts with an inherent premise — all things remaining more or less equal, what are our risks?

Well of course, the biggest risks — the strategic risks, are that all things don’t remain equal ie, underlying conditions change. If you look for the changes in underlying commissions at a global, regional and local scale, the black swans become easier to see.

Some black swans to think about

Here are a few changes on the horizon to think about, which in turn generate new strategic risks.

  • peak oil:
  • peak soil:
  • climatic temperature limits:
  • peak debt:
  • peak workforce:
  • biodiversity loss:
  • food and water scarcity:
  • peak phosphorous:
  • reverse globalisation:
  • industrialisation of China to the point of economic self-reliance: and
  • the end of the commodities boom before the end of the decade.

Have you ever wondered

  • Why sovereign wealth funds are rapidly buying up agricultural land, water and energy resources around the world, but not necessarily hard commodities?
  • Why are they doing this at accelerated rates and prices?
  • Why does Australia’s national security strategy focus on food security and climate refugees instead of traditional warfare methods in areas of existing conflict?
  • Why are large oil spills off our coast and in the Gulf of Mexico are increasing in frequency and severity?
  • Why does the peak body on global risks rate food security and biodiversity loss among its greatest risks to global economic growth?
  • Why is China investing in cleantech and greentech faster than most of the developed world (especially Australia).

The clues to these questions lie in the changes in conditions set out above. The strategic landscape is changing, and along with it your strategic risk profile.

Put simply, if your risk profile isn’t considering these sort of effects, there’s a good chance there’s a big black swan sitting in your organisation, industry, country, economy or world view. The same applies if your strategy and risk processes aren’t talking to each other, or you’re using a 1990’s strategy process at your organisation. Red flags indeed.

What’s the best way to deal with black swans?

At this time of year a good bit of contemplation and reflection is in order. I’d recommend getting up to speed on these issues with an enjoyable read or two over the festive season.

Read anything by Ian Lowe, particularly if it talks about cricket. Or anything by Kurt Vonnegut for that matter. Or if you really want some fun, Dirk Gently’s Holistic Detective Agency is also great stocking filler. All will prepare you for well for strategic risk thinking and some of our articles in the New Year.

So with that its time for some good wishes for the festive season.

  • May we all be less like ostriches.
  • May our turkeys end up on our dinner tables and stop gambling with our retirement funds.
  • And may your black swans become visible to all so we can come together to face the challenges of our times.

Have a safe and festive holiday season and I look forward to taking you through some specific strategic risks in the New Year.

This article first appeared in the December 2010 issue of Risk Management Today.