Planning for a World of Black Swans

In a recent Huffington Post piece, "Planning for the Unimaginable," Terry Newell asserts we must get better at planning for and reacting to so-called "Black Swans" (the term popularized by Nassim Taleb for seemingly unpredictable extreme events). To do so, Newell recommends that we "institutionalize thinking about the unimaginable."

Newell's attitude is refreshing. Volatility is the result of market economies, global capital flows, and ever more powerful information technology -- and thus a price we pay for innovation and growth. Better that we learn to live with it, than try to wish it away.

To anticipate Black Swans, or react quickly and accurately when they surprise us, requires a special way of thinking. But textbooks offer little help. For all his prescient warnings, Taleb does not tell us what to do. Difficult enough for individuals, decision-making in a world of volatility is even tougher for institutions. Last week, the German government decided to ban naked short selling in order to reduce market volatility -- and sparked a global market sell-off, crushing investor confidence. Newell is right: we need our institutions to be smarter at dealing with volatility.

Where should we start? As individuals, we can become more effective decision-makers by adopting a number of common-sense techniques, many of which derive from Wall Street practices. To be sure, Wall Street makes plenty of mistakes, but its sharpest analysts and traders have much experience with volatility, for the simple reason that they deal with it day in and day out. Here are some suggestions:

• Practice the craft of fundamental research, that is, in-depth study of causative variables that help us predict outcomes (and sometimes anticipate a Black Swan). The discipline of Ben Graham and David Dodd (Warren Buffet's mentors), investors have more recently used fundamental research to predict the subprime crash and the collapse of the Euro.
• React intuitively to new information. Financial institutions rely on high-powered quant models to value complex securities. But these models pale in comparison to the power of human intuition to spot new patterns. One of the reasons that the US mortgage industry was blindsided by the subprime crash was that its decision-makers became dependent on models built on historical data, and missed clues that conditions were changing.
• Learn to acknowledge we're wrong. A tough challenge for all of us, being wrong can trigger episodes of "cognitive dissonance," in which we dismiss new data that contradicts our deeply held beliefs, rather than reacting to change. That's why experienced traders follow a "stop-loss" rule, which forces them to close out a position when they're wrong. Similar protocols can help individuals and institutions react more quickly.

Individuals may follow these and other common-sense principles to more effectively make decisions in a world of Black Swans. But Newell has laid down a tougher challenge: how do we make our institutions smarter at dealing with volatility? Every institution is different, but here are some general ideas:

• Financial regulation should focus more on fast response to crisis, and less on trying to limit volatility through ever more complex rules and regulations. One idea for fast response is "contingent capital," a form of debt that would automatically convert to equity in a crisis, immediately stabilizing a weakened financial firm without requiring an infusion of taxpayer funds. Rules and regulations are not likely to prevent volatility, especially if firms figure out how to get around them. For example, the enormously complex body of rules governing bank capital (known as "Basel II") not only failed to prevent the crisis, but actually made it worse, by allowing European banks to operate with unprecedented leverage.
• We should rotate officials in positions of power more frequently so as to minimize the risk that successful leaders become entrenched, making it hard for them to anticipate or react to change. For example, Greenspan's long tenure and excessive market confidence in his skills (the so-called "Greenspan put") may have contributed to the severity of the housing bubble and crash. I have argued the Federal Reserve chairman's service should be limited to a maximum of ten years.
• Institutions should implement emergency protocols to help them react more quickly to Black Swan surprises. For example, in the corporate realm, a senior strategist could report directly to the board of directors when volatility indicators start flashing, bypassing the CEO who might be struggling with cognitive dissonance.
• Institutions could allocate more resources to fundamental research. For example, it might be helpful to have a council of financial regulators charged with anticipating future systemic risk (not just studying past crises). Risk managers could take a break from their quant models and spend more time studying how economic and industry cycles, competitive strategy, and management incentives contribute to risk.