The fallacies of risk management
Imagine the following scenario:
A commercial airline flight takes off for its specified destination. Unfortunately, the weather at the destination is so bad that the pilot is unable to land. As they execute the missed approach, the plane runs out of fuel and crashes – all on board are lost.
Can you imagine the tragedy, law suits, inquiry and resulting government regulations? The public reaction would be (rightly) overwhelming. Fortunately, there are already regulations in place not to mention extensive pilot and dispatcher training that would make this imaginary scenario (thankfully!!) almost impossible.
Every flight should be planned in advance with a set of contingencies designed to cover the unexpected or to recognize that the assumptions made for the flight are not working out. Contingencies include planning an alternate destination, carrying extra fuel and as the ultimate back stop, finding a runway and getting on the ground as soon as practical. Pilots train for these situations and commercial flights also have a high degree of redundancy in systems (engines, power sources, flight controls etc.) designed to minimize the impact of the 1% improbabilities.
The process of building a contingency plan has been drilled into me by every flight instructor and recurrent training session I've had. If I can't build an adequate contingency plan, I don't fly. It's that simple. Not surprisingly, this form of thinking has carried over into other aspects of my life including investing.
Yesterday's New York Times magazine had a great article showing the impact of the 1% improbabilities in investing – Risk Management and how the professional investors got nailed by the Black Swan events of the meltdown. It's well worth a read regardless of whether you are an investor or an entrepreneur.
If you are a CEO of a company (big or small) you need a contingency plan that thinks about the possible 1% events and how you will react to them – fortunately, the US Government thinks about such things too!
Don't fall into the "oh, we'll deal with that if it happens" trap that I've heard so many times in board meetings over the years. There is too much temptation to put aside the really hard issues that may be improbable- they are uncomfortable to deal with and don't have clear cut answers. As a CEO or board member you should make sure that these issues are put on the table and discussed ahead of time.
It may turn out to be unnecessary but when (not if) the improbable occurs, you will be much better prepared and the actions you take will be considered, not reactive. This will help the company better cope and survive the unexpected. Today's environment is so out-of-the-norm that events you think are improbable are much more likely to occur.
Don't find yourself the victim of fear and surprise…