Is that a black swan lurking just around the corner, ready to sow chaos and devastation? Or is it a false alarm?
Black swan is the term popularized by the writer Nicholas Nassim Taleb for a seemingly unpredictable surprise with extreme consequences. Many people apply the term to the housing and financial crash of 2007-2009. But the term should not be restricted to global crises. Black swan surprises can impact individual sectors or companies, even when the rest of the market is calm.
The real problem with black swans is that, while they may seem obvious in hindsight, they are anything but beforehand. Corporate executives (and risk managers) need a system to help them make decisions before the black swan has arrived, at which point it may be too late to take action.
And it had better be a pretty good system, because the consequences are severe: Fail to act and the company could be destroyed. But an executive who jumps at shadows may miss out on the opportunity to invest and grow.
Early-warning Indicators
Once a black swan has arrived, there may be little time to react — it might even be too late. But just because a black swan might be flapping around somewhere off in the distance — that doesn’t mean it’s time to run for the bunkers. What would help is an early warning system that separates potential risk from imminent danger.
This early warning system should have three components. The first component is a process for identifying potential risks. It’s fine if this process is largely intuitive. After all, most executives understand the risks unique to their business. Start by writing them down. Then open the newspaper. What macro risk factors are people debating? Add them to the list.
Back in 2007, there was a huge debate about the housing market. With hindsight, we now know that most people were too optimistic, and only a few foresaw just how bad things would get. But housing market risk wasn’t a secret. Everyone was talking about it. And therefore it should have been on every executive’s list of potential risks.
Today, a list of macro risk factors might include economic growth in China, the ongoing debt crisis in Europe and political uncertainty surrounding the United States budget deficit.
The second component of an effective early warning system is a list of key risk indicators, i.e., data points that measure the company-specific and macro risks on the list.
For example, in 2007 key risk indicators for the housing market could have included home sales or home price appreciation, which are published on a monthly basis. Today, key risk indicators might include debt spreads for European government bonds, quarterly GDP growth for China or U.S. Treasury yields.
The third component is a set of limits for each key risk indicator. These limits define “normal” and “danger” zones. For example, a limit for Chinese GDP could be set at, say, 7 percent, in which case, a reading of 8 percent would be considered normal and 6 percent would be considered “danger.” Indicators in the danger zone should force executives to confront and discuss impending risk. It’s like setting off a siren.
If a company can afford to invest additional resources into its early warning system, it may be able to design more sophisticated indicators and — possibly — get an earlier warning of impending problems.
Such investment consists of hiring research analysts to study and understand the risk factors and their underlying causes and possibly paying for proprietary data sources.
For example, a company relying on home price appreciation as an indicator might not have seen the danger of a housing crash until 2008, whereas those monitoring spreads on mortgage securitizations would have heard the sirens go off in 2007.
Today, if executives are concerned about Chinese economic growth, they could wait for quarterly GDP statistics to be published. Or they could subscribe to publications that track stockpiles of commodities and raw materials in certain Chinese port cities, which might provide an early read on economic growth.
No organization has an unlimited budget. For those that cannot hire analysts, a low-cost alternative is to use market indicators, such as prices for stocks and bonds of companies in relevant sectors of the market. Watching market prices won’t provide an early warning, at least relative to investors. But watching the market might save the organization from being the last to know.
One market indicator that all executives ought to watch is the Chicago Board Options Exchange Market Volatility Index (VIX). This index measures the volatility implied in options on the stocks of the S&P 500. As such, the VIX is a measure of investor uncertainty.
As of Dec. 31, 2012, the VIX was at 18 percent, close to the average over its 23-year history, above lows of close to 10 percent, which were seen in the mid-1990s and mid-2000s — which we now realize were boom times — but well below the peaks of the crisis, when the VIX briefly touched 80 percent.
A VIX reading above 20 percent ought to be a danger indicator in everybody’s early warning system.
Flexible Planning Horizons
Consider the busy executive sitting at a desk, drinking a cup of coffee, and the early warning report is brought in — with numerous indicators flashing red. Now what?
The main difference between decision-making during a crisis and normal times is the length of the planning horizon.
In normal times, large companies go through extensive strategic planning processes, which typically produce long-term forecasts. Remember Countrywide Financial Corp., the mortgage company that became the poster-boy for bad lending practices? Prior to the crisis, Countrywide was regarded as a well-run company, and its executives were proud of their five-year strategic planning cycle, which they had followed with success over three decades.
Of course, not every company goes through a five-year strategic planning cycle, though most would go through a one-year budget cycle. But in a crisis, even one year is an awfully long time.
Think about what the VIX means. Volatility is shorthand for “standard deviation.” Recall from basic statistics, a range of plus or minus one standard deviation is supposed to correspond to a 67 percent probability. Translated into plain English, if the VIX is reading 18 percent, that means that investors are betting that a year from now, there is a 67 percent probability that the S&P 500 will end up somewhere within a range of plus (+) or minus (-) 18 percent from its current level.
In a crisis, if the VIX is at 80 percent, then market participants have no idea what is happening. They’re braced for the sky to fall. In this kind of environment, does it make sense for a company to look out five years or even one year? The answer has to be no.
In a climate of extreme uncertainty, the executive needs to throw the strategic plan out the window. Forget long-term forecasts, and focus completely on the short-term. Survival might hinge on snap decisions made immediately, with only scraps of information to go on.
Part of the reason Countrywide failed was that its executives clung tenaciously to their strategic plan, according to which market share was the top priority. Winning market share required offering a wide range of products, including subprime and option ARMs. Countrywide kept originating these loans well into 2007, even as the securitization market froze, forcing the company to keep even more toxic paper on its balance sheet.
Bank of America Corp. (BofA), too, got into trouble by sticking to its strategic plan, according to which it was going to build the leading consumer lending business, by snatching up credit card and mortgage companies, like Countrywide, when it stumbled.
In contrast, as the crisis raged, some of the smartest hedge fund managers (including those who made fortunes betting against Countrywide and Bank of America), moved completely into cash. Even those operators — whose businesses are built upon exploiting market volatility — found the crisis too much to deal with.
Eventually, even the most severe crisis comes to an end. When the key risk indicators return to normal levels, then it’s time to climb out of the bunker, dust off the strategic plan, modify it for the new reality and begin looking further out into the future again.
Governance and Delusion
Early warning indicators and flexible planning horizons are some basic tools for managing black swan risk. But there’s another risk to contend with, one that may render these tools useless.
Picture the hard-working executive who receives the latest early warning report while sipping a cup of morning coffee. What happens if he tosses the report in the trashcan, muttering “bunch of nonsense — that’s not what I think!”
After all, Countrywide and BofA weren’t the only firms that disregarded the warning signs. What about the investors who continued buying their stocks — and the stocks of other ill-fated financial firms, like Lehman Brothers, Washington Mutual Inc. and Fannie Mae?
There’s a technical name for this flaw in human reasoning: “cognitive dissonance,” which describes a pattern where people make poor decisions because of personal issues that cloud their judgment. Another term is “self-delusion.”
The executive who dismissed the early warning report as “nonsense,” might be struggling with an uncomfortable implication: if he throws away the strategic plan he had just persuaded the board of directors to endorse, maybe that’s a sign he isn’t such a skilled executive after all. Maybe the board will look unfavorably on him. Maybe they will think about replacing him with a rival. Maybe it would be better to ride out the storm and see if the black swan goes away.
From a purely selfish perspective, these are rational considerations. But they don’t help the company face up and take action.
In the book by this author, Stalking the Black Swan: Research and Decision-making in a World of Extreme Volatility, is a discussion of a number of protocols for managing cognitive dissonance. To some extent, one can train oneself to recognize the symptoms, which could include feelings of anger, irritation or a cold drop of sweat rolling down one’s brow.
But there is a limit to self-awareness. One technique for combating cognitive dissonance is to bring in teammates. Peer reviews can help shake a person out of a state of self-delusion.
Humans are all vulnerable to delusion. That’s why corporate governance is so important in organizations.
The board of directors should review the same early warning reports and then watch executives for signs of self-delusion. Does the CEO get impatient or angry when people discuss risks to the strategic plan? Does she dig in her heels and refuse to contemplate the possibility that big changes are needed fast? If so, the board may have to exercise its prerogative and replace the CEO with an executive better suited to face a volatile environment. After all, it does little good to replace the CEO after the company has failed.
In summary, it is impossible to know with certainty whether the next black swan is getting ready to strike, or it might not. Honestly, it’s hard to tell. But don’t wait to find out.
Companies should take the time now to invest in early warning systems, flexible planning horizons and strong governance. These tools will give them the best odds of making the right decision — while there’s still time to act.
Kenneth A. Posner is chief of Investment Analytics for Capital Bank Financial Corp. and author of Stalking the Black Swan: Research and Decision-making in a World of Extreme Volatility, (Columbia Business School Press, 2010)