With the US providing air support in the ISIS fight, memories of earlier Gulf Wars come to mind, particularly of Donald Rumsfeld, Bush the Younger's Secretary of Defense.
Rumsfeld had at least two endearing qualities. First, he could aggravate just about anyone -
of either party - inside the Beltway. Second, he was and continues to be a source of short, pithy statements that say quite a bit in very few words.
My favorite of these is "Unknown Unknowns," something he distinguishes from "Known Unknowns." In short, his point was that while knowing what you don't know is important for planning and decision making, it's the things that are not even on your radar as threats that can really come back to bite you.
The problem with these Unknown Unknowns is that because you're unaware of them, they are not a risk but, rather, a form of uncertainty (See my
June, 2014 newsletter for more on the difference). In other words,
you can't predict the odds of an Unknown Unknown
because it is not in the set of possible outcomes. Risk transfer, probabilities, Monte Carlo simulations can't help.
And, even though Unknown Unknowns are a
form of uncertainty, they are still different than most. How? Uncertain events are possible outcomes that we know of but cannot predict in any statistically meaningful way. Unknown Unknown events, on the other hand, are not even uncertain events, because they don't enter our set of possible outcomes.
All that said, the
possibility of something happening that we can't conceive of is itself knowable, because these continue to happen throughout the course of history. To some extent, these are similar to Nassim Taleb's "
Black Swan Events."
Ok, so much for theory.
What can we do as business people to deal with these Unknown Unknowns?First, minimize their occurrence. Second, prepare for them.
Minimize the Unknown Unknowns - by knowing themConsider the mortgage crisis of 2008, which was not foreseen by most of the big banks, trading houses or the Federal Reserve.
As early as 2005, I attended conferences on distressed investing, with speakers talking about the increase in default rates of
subprime mortgages. They highlighted the fact that the rating agencies were using the default history from first generation subprime mortgages to predict default rates for subprime mortgage issues several years later (despite evidence that recent subprime mortgages were defaulting much sooner and at a higher rate).
Back then, people were already talking about how servicers were not paid enough to properly service defaulted mortgages, effectively foreshadowing robo-signing and other mortgage servicing problems that happened right after the crash. Additionally, institutional investors such as Jeremy Grantham of GMO, LLC and economists such as Noble Prize winner Robert Shiller from Yale, were sounding the alarm about a housing bubble. Statistically, and according to Grantham, the rise in housing prices was a 2.5 sigma (1 in 5000 years) event.
And yet the crisis was still missed by most people.
So what's the solution?
Start by looking for conflicting information. Our brains focus on information that confirms what we believe - and avoids the rest. Wall Street didn't want to believe housing was a bubble, despite the strong evidence to the contrary, because they were making so much money from it. And times were good, so the Fed didn't want to believe it either. So work to get information outside of "normal" business channels.
Spend time outside your business or business unit. Organizations necessarily filter information that flows up to decision makers, leaving you open to being blindsided. Get the information you're missing by walking around and being approachable. People will communicate in an unfiltered way if you are out and about and
are known for listening.Milton Freedman is famous for striking terror in Ph.D. candidates by asking "How do you know that?" again and again. Eventually, he would drill into what was missed or not understood. Do the same when people are presenting a situation assessment or asserting something as fact.
Prepare for the Unknown UnknownsIn 1957, Dwight Eisenhower said:
"Plans are worthless, but planning is everything. There is a very great distinction because when you are planning for an emergency you must start with this one thing: the very definition of "emergency" is that it is unexpected, therefore it is not going to happen the way you are planning."
By planning for what we know might happen, we are in a better position to respond when the unknown reveals itself.
- Do normal disaster planning. To the extent the impact of the unknown is similar to what you planned for, you have a head start. Always be able to contact critical employees, customers and vendors, no matter what happens.
When the S. S. Pierce Company took on the Teamsters in an 18-month strike, for example, I had the name, address and phone number of all employees with me, at all times. The sales manager had a similar contact list for all customers and the head buyer had the same for all suppliers.
- Have extra resources on hand. Regarding finances, that means cash or borrowing availability. It also includes people, management time and calendar time. The whole principle behind the Fed's stress tests, capital requirements and liquidity requirements, for example, is to be sure banks can weather the unknown when it happens.
In the Teamster strike I mentioned, liquidity was not a concern; we were owned by Phillip Morris. But access to that liquidity was. To guard against this, I had manual checks stored offsite and $50,000 in cash in a briefcase. I don't recommend carrying cash in a briefcase, but I do recommend keeping credit lines that provide ample liquidity.
- Assess risks on an enterprise-wide basis. By building a platform that is broader than your individual business unit or function, you will plan for more possibilities and have more support, if needed, in the event of an emergency.
The key to handling Unknown Unknowns is to reduce their number and plan for their eventuality.
We don't know where, when and how they're coming, but we do know that, sooner or later, they will arrive.
