Nasim Taleb, the author of The Black Swan, offered this advice to managers of non-financial companies in a recent McKinsey Quarterly interview:
Be hyperconservative when it comes to downside risk, hyperaggressive when it comes to opportunities that cost you very little. Most people have the wrong instinct. They do the opposite...Don't fear being aggressive if that only costs you a little. Do more trial and error. Learn to fail with pride, comfort, and pleasure. But try to have less downside exposure by building more slack into your system through redundancy, more insurance, more cash, and less leverage...My idea is to base your navigation on fragility.
His advice is grounded in his experience with, and careful analysis of, "black swans." Per Taleb,
My black swan is an event with three properties. Number one, its probability is low and based on past knowledge. Two, although its probability is low, when it happens it has a massive impact. And three, people don't see it coming before the fact, but after the fact everybody saw it coming.
Taleb and others have made the compelling case that "in the historical and socioeconomic domain, black swans are everything." For example, the unexpected growth of the Internet and the sudden collapse of global debt, equity, property, and commodity markets are two such events--one positive and one negative--that have dominated the economy over the last decade.
We can't predict black swans. Nevertheless, we can be confident black swans will continue to occur. What Taleb is saying is that we can do a better job preparing for their appearance. That is, we can hedge against the unlikely, but potentially devastating, negative black swan while we make numerous, relatively small investments in opportunities that offer at least a small chance of a large reward.
For instance, the practice of open innovation has the potential to provide companies with the ability to make relatively small investments in highly uncertain, but promising, concepts for new products. Most companies, however, under-invest in the possibility of catching a ride on the rare positive black swan and, as a consequence, are over-exposed to the rare, but potentially deadly, negative black swan.
Let me give you an example:
My colleagues and I know of a multi-billion dollar company that makes very common household products. Its brands typically have a #1 or #2 market share. Over the years, the company has grown through acquisition and assiduously cut redundant costs (such as R&D capacity). Its manufacturing operations are efficient. In other words, there is much to be admired about this company.
However, the company's management is anxious. As the company has focused on efficiency, it has constrained its ability to experiment. There is little slack in the system. Consequently, the rate of new product introductions has been very sparse. As its core products have matured, they have been commoditized. Capable, private label competitors have taken market share. Major retailers have consolidated their vendor relationships. Volatile raw material costs drive margins. Ominously, the company has seen a double-digit decline in the sales of its traditional, branded product line over the last several months.
With a leading position in mature, commodity markets, this company faces a lot of downside and probably not much upside. Its manufacturing efficiencies are already top-tier; it has no market power over the cost of its raw materials; and the evidence clearly suggests that the power of its brand is rapidly eroding.
Betting on the resurgence of its core business might be a viable strategy. On the other hand, it might make a lot of sense for management to hedge such a big bet by making several small investments in promising new products. These could be internal R&D projects, licenses, investments in new ventures, and acquisitions of promising young companies.
However, the company seems to be closing its doors to such opportunities. It has actually withdrawn new products from the market in order to focus on its core business. In relative terms, management appears to have decided to eliminate low cost/high opportunity options in favor of "doubling down" on its existing businesses, which are (for the moment) large but offer little upside.
Like Taleb, we see this pattern of behavior repeatedly. Uncertainty is confused with risk. Managers inadvertently take risk under the false assumption that large investments in "proven" business are safe. Most days they are right. However, the black swan lurks, and tomorrow could be a disaster. By investing solely in familiar businesses, management trades potentially crippling downside for limited upside. Meanwhile, managers tend to be overly cautious when it comes to making small investments in uncertain, but promising opportunities. Consequently, they fore-go the chance for transformational upside.
The execution of Taleb's advice requires courage, tenacity, and a system that supports continuous, inexpensive failure in the hunt for occasional, highly rewarding success. It's the rare company that has what it takes.
Not so smart Kathleen here again. I can't always wrap my head around the implication of what you write. I'm here today grateful for a break, we're in the midst of a heady crisis.
At this point, many in my industry are hosed. A definite black swan. Or maybe not, you're the better judge (I have the book, didn't get past cherry picking topics). I mean, we have this huge crisis that came out of nowhere, nobody saw it coming and the potential for devastation is such that when we describe it, the media thinks we're nuts, wild-eyed kooks. I mean, WE didn't believe it. Somebody told me about it last August, I ignored it. People are either in absolute panic, depression or denial. The scope of devastation it represents is just not conceivable to the average person so they surely think we're exaggerating.
Okay, let's just say that I told you that next February 10th 2009, most of the manufacturers of children's products were going to go out of business and that retail outlets with significant exposure to the niche would be similarly affected. You'd say I was nuts. I don't blame you. What if I told you that everything from children's video games, clothes, strollers, car seats, and toys would be pulled from store shelves. You wouldn't believe me. I don't blame you. Half the time I don't believe it myself.
The difficulty is the unintended consequences of H.R. 4040. Due to complexities I'll spare you, retailers will be requiring the largest of manufacturers to supply them with general conformity certificates for lead issued by a CPSC approved third party testing lab. The law doesn't require this until August but retail doesn't have the infrastructure of grocers to pull product with varying expiration dates so they want this now.
Anyway, before you become convinced I'm completely unhinged I did want to address the matter of fragility. We are fragile; even once it came down the pipeline, we're pretty powerless to do much about it. One thing that's always struck me about my industry is the fragility of our communal infrastructure. We're so fragmented that even when under a cloud such as this, we're close to powerless to doing anything about it. Manufacturing as a matter of course, tends to reward or make hero of the lone inventor mentality you wrote of; if only internally. I've done what I can towards the end of community creation but in the end, the residual is we're our own worst enemies...
And if you're interested in watching a case history unfolding, see nationalbankruptcyday.com or fashion-incubator.com, category CPSIA
Posted by: Patternmaker | December 11, 2008 at 02:56 PM
They are fascinated insights Kathleen. I presume toy-makers with less exposure to the US retail market will be spared much of the trauma here (and may be able to survive the transition). I'll have a look around for more information on this change.
By the way, I also review Taleb's book recently (http://internationalbs.wordpress.com/2009/01/03/the-international-bs-book-club-iii-the-black-swan/)
Posted by: Andre Sammartino | January 04, 2009 at 05:20 PM