C&B Notes

Expecting the Unexpected

We enjoy studying Nathan Myhrvold’s thinking, and this column explores an idea that is an integral piece of our investment process. Namely, it is vital that we think about how companies are positioned to mitigate risks — not just obvious ones on a typical scale, but also rarer risks on a grander scale than have occurred in the past (we have written on this front in the past here and here).

Complacency is baked into our species. We can’t resist thinking that recent experience defines the future.  Give us a run of good luck, and we are apt to turn that into an implicit expectation that our luck will continue — even that we are entitled to it.

This kind of thinking was instrumental in the run-up to the financial crash of 2008.  Too many private and public institutions assumed that an extraordinary run in prosperity, particularly in the real estate market, was just normal.  It didn’t occur to them that things could go so wrong.  Even when token stress testing or risk assessment was done, it largely excluded the possibility of a bad shock or a protracted slump.  Risk wasn’t systematically measured; it was ignored.

It’s easy to write this off to greed or foolishness on the part of Wall Street.  But the truth is, our entire civilization rests on a foundation just as shaky.  We assume that the very Earth is static and will always be as it is now, or as we remember it.

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Yet geophysics tells us that is emphatically not the case.  Bad things happen.  In the past couple of years alone, we have witnessed a litany of horrific natural disasters.

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The probability that really bad things will happen is low — but it isn’t zero. Its rarity only lulls people into a false sense of security.

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The lesson is simple to state, but hard to follow: Risks with heavy consequences must be taken seriously even if the probability of their happening tomorrow is low.  That means incurring small, but real, costs in the here and now to mitigate the damage from some disaster that may lie far in the future — even though “far” means beyond the present budget cycle, after the current chief executive officer has retired, or after the current politicians have left office.  Only by thinking and training in anticipation of the inevitable can authorities avoid getting blindsided.

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