Small Risk is Not Zero Risk

In the early weeks of March, many in the tech sector were surprised and distressed by the sudden collapse of a once-great institution, Silicon Valley Bank (SVB).?Founded in 1983, it was the 16th largest bank in the US and was a very active and positive influence on the technology sector — in Silicon Valley, of course, but also significantly in the Boston area.?

There are a variety of explanations behind this sudden turn of events. But there was one primary issue:?the bank did not adequately plan for the very small probability of a very bad outcome.?

To vastly oversimplify what happened, SVB assumed interest rates would stay low for the foreseeable future (as they had in the recent past) and made investment decisions based on that expectation. It made sense… until it didn’t, when the very bad, very small probability event occurred: a dramatic increase in interest rates over a short period of time.?

It’s not that the bank had no warning — indeed, it was notified?more than a year prior?of the excessive risk it was carrying by the Federal Reserve Bank (The Fed). Or that its leaders didn’t understand what would happen?if?rates rose quickly and significantly. But one presumes they took comfort in the fact that while the consequences could be severe, the likelihood of it happening was small.?

But small risk is not zero risk.?And that’s a problem for all of us — humans have difficulty imagining these situations.?

For example, many years ago I was involved in a project with a major telecommunications company that enjoyed a highly profitable business leasing telephones to consumers. They had begun to experience a rapid erosion of this business and I built a model to test several possible scenarios to gauge the impact of various responses.

Despite using reasonable (and sometimes even aggressively positive) assumptions, the model suggested that there was no way to reverse the trend.?The client’s response? Keep working on the model until you get the outcome we want.?I tried several more times, but reality refused to listen.?

Waiting Can Be Dangerous

?When it comes to these types of low probability, high negative potential events, the problem, generally, is not a failure to understand the magnitude of the risk.?It’s waiting too long to respond to any signs that the risk might be increasing, at which point, options become far more limited.?

As I have written about previously, people have a lot of trouble understanding the impact of exponential change. Even when things begin moving in a negative direction, if it starts small and slowly, there is a tendency to assume the trend will continue and the impact will remain limited and manageable and not accelerate in the future.?

The blinders tend to be?particularly difficult to see around when the organization in question has been successful and influential in its market for a long time.?They have weathered storms before and so have confidence that they always will.?

In a related, personal case, my health has been significantly impacted for the better, thanks to a doctor who understood this concept. Twenty-five years ago, and based on a minor symptom I was experiencing, he took steps to investigate deeply. The likelihood of something very bad was small (but not zero) and thanks to his intervention, I’m far better off today!?

What to Do?

?So, if small likelihood risks can lead to significant negative events,?does this mean steps should be taken to mitigate against?every?possibility??Should I wear a helmet in my house to guard against the chance I might fall and suffer a serious head injury??

Clearly the answer is no. Trying to eliminate?all?risk is neither feasible nor desirable.?The challenge is in striking a balance.?

Things to consider…?

Impact.

?Any situation that is?likely to significantly affect your strategy — pricing changes, new technology, new government regulations, etc. — is one that should be considered in your planning.?Others are less important.

?The impact of your preferred office cleaning service going out of business would be low; the impact of a now small competitor growing in size and stealing a significant amount of your market share would be high.

?Timing.

?Degrees of risk are not static.?Today’s unlikely occurrence can increase in likelihood over time.

SVB knew more than a year ago that the Fed would be raising rates and that the value of their bond investments would drop as a result. Had they reevaluated the risk likelihood then and responded — even if it meant selling some of their holdings at a loss — the magnitude of the loss they ultimately experienced may not have been existential.

?So?it’s important to keep track of all identified risks?and continually assess both their probability and how bad the downside might be if they were to occur. On a regular schedule — during an annual strategy review, at least, but likely more often — you should be assessing the market situation, considering any notable trends, news items, and new activities by competitors.

?Action.

?As the different risks a business faces rise and fall in probability, it’s important to game out possible plans of action.?How might we respond if scenario X occurred? What would it cost? What would be the impact of doing nothing?

?Not only do your options narrow the longer you wait to respond, but the absolute worst time to think through these options is while the bad thing is actually happening. That’s why we have fire drills, cybersecurity tabletop exercises, and football practice.

?Reflections

?The key point is that all risks — even ones that seem tiny (or far in the future) — are worthy of consideration and monitoring, particularly if what is at stake might be very serious.

The earlier you can identify that a particular risk is beginning to trend badly and act on it, the better off you will be in the long run.

-------

If you are reading this newsletter here, you are reading an abridged version. Plus, you're getting it about a month late. To subscribe to the "real thing,"?follow this link.