Welcome to our second Ezine of 2016. A number of businesses, including the IT sector, in recent months have experienced a sharp drop in sales turnover, owing to a plethora of reasons, some globally and some closer to home in South Africa.
With world commodity prices on a downturn, political unrest before the elections, Nene-gate and a potential sub-investment grade derating in December, companies are understandably disinterested to invest in such an uncertain environment. Other factors such as a declining oil price and the Brexit saga only fueled this environment of uncertainty.
With the benefit of hindsight, business owners had sufficient time to anticipate the different risk scenarios and prepare for the lower sales or cash flow difficulties that this period could produce. However, how many business owners or board of directors, plan for a possible low-risk, high impact financial event that is beyond the realm of normal expectation?
To understand this a bit more, let us take a step back to the concept of a Black Swan. Originally a Latin expression “rara avis in terris nigroque simillima cygno” (which means that a good person is as rare as a black swan), it was quite common during the 16th century in London to describe something that was impossible or did not exist. We need to remember that up until the discovery of actual black swans (Cygnus atratus) in Western Australia in 1697, historical records showed that all swans had white feathers.
Nowadays, unexpected events are referred to as a Black Swan, which is a theory developed by the author Nassim Taleb to explain rare case scenarios that would normally be considered extreme outliers and to explain the psychological biases that make people individually and collectively blind to uncertainty and unaware of the role of such a rare event.
These Black Swan unpredictable events in history play a much bigger role than normal occurrences. Some examples are the September 11, 2001 attack on the World Trade Towers or the birth of the Internet and the effect it would have worldwide on ordinary people’s lives. Not to mention the way we do business!
In his book, Taleb predicts that banks, insurance companies and trading firms are most vulnerable to a Black Swan event owing to the fact that their financial losses invariable are much worse than their business models could predict. Think of the recent global financial crisis and the impact it had on some of the big name firms. Lehman Brothers, Citibank, Bear Stearns and AIG come to mind. The all had risk vs value models that could not predict the fall-out of the subprime mortgage meltdown. These businesses were all viewed as too big to fail.
The idea is of course not to try and predict such Black Swan events but to ensure that systems or failsafe mechanisms are in place for “worst case” scenario planning and more importantly, to exploit positive Black Swan events opportunistically when they occur in business.
All Black Swan events have a central and unique attribute, low probability, but high impact.
An interesting “in the eye of the beholder” observation is made by Taleb, in that a negative Black Swan event may be completely differently perceived as a positive event by another party. As an analogy, think of a turkey being shot and killed. The Black Swan event may surprise the turkey, but certainly bodes well for the hunter. For a business owner, the lesson here is that we should try to “avoid being the turkey” and identify areas of vulnerability in their business so that they can “turn the Black Swan white”
Taleb identified three criteria for a Black Swan event in business:
- The event is a surprise (to the observer).
- The event has a major impact.
- After the fact, the event is rationalized by hindsight, as if it had been expected.
- What is fragile should break early while it is still small. Nothing should ever become Too Big to Fail.
- No socialization of losses and privatization of gains.
- People who were driving a school bus blindfolded (and crashed it) should never be given a new bus.
- Do not let someone making an “incentive” bonus manage a nuclear plant – or your financial risks.
- Counter-balance complexity with simplicity.
- Do not give children sticks of dynamite, even if they come with a warning.
- Only Ponzi schemes should depend on confidence. Governments should never need to “restore confidence”.
- Do not give an addict more drugs if he has withdrawal pains.
- Citizens should not depend on financial assets or fallible “expert” advice for their retirement.
- Make an omelet with the broken eggs.
Most stock market risk profiling systems could predict the outside event of a possible Black Monday (1987) disruption which was a “known unknown”, but none considered the low probability (but high impact!) of a complete global financial banking system meltdown.
In essence, one has to consider the case scenario of the unknown unknown occurring in business and ensuring that there are robust systems in place to deal with such an unexpected event.
In conclusion, Taleb believes that the one fallacy belief we all have is that we assume that the unstructured randomness found in life resembles the structured randomness found in games. He therefore advocates strongly the use of counterfactual reasoning. (Otherwise known as “what-if” scenario planning).
We hope you enjoy this edition of our quarterly e-Zine and thank you for your continued support of First Technology!
Johan de Villiers