Predictable surprises and asset management

Surprises will occur. It is a part of live in any asset market. If markets are efficient, then prices will react to rebalancing, hedging, and when there is some unanticipated information or news. This is a simplification, but it is one of the key working premises of the efficient market / rational expectations paradigm. Some of these surprises are truly out of the ordinary, but many are predictable. Over valued stocks or bonds, a Fed action, a supply shock. All can be surprises, but all have some level of predictability. An important way for a asset manager to create value is through preparing for these surprises or making them more predictable.

It may seems like an oxymoron to say we can prepare for predictable surprises, but it has been the subject of good book by Max Bazeman and Michael Watkins, Predictable Surprises: The Disasters You Should Have Seen Coming and How to Prevent Them. This book is over 10 years old; however,  it is filled with insights that can be employed by any money manager. The book focuses on organizational dynamics, but the thoughts of how to deal with surprises can apply to any money management organization.

So what is a predictable surprise? There are six general characteristics:

1. We knew a problem exists and it will not solve itself.
2. The problem is getting worse.
3. Fixing the problem will incur significant costs and the benefits will not be immediate.
4. Addressing the problem will have certain costs while the reward is uncertain.
5. An organization fails to prepare for the surprise because of the tendency to maintain the status quo.
6. There is a vocal minority that benefits from inaction.

The case of September 11th and the Enron collapse are just two simple examples of predictable surprises. With September 11th, there were many signs of a a potential problem. The costs of better preparing for an extreme event just seemed too high relative to the expected reward. The US government missed it. In the case of Enron, special interests, conflicts, and an unwillingness to confront problems all contributed to the blow-up. The Great Financial Crisis a perfect example of a predictable surprise. Many saw it coming but did nothing because the costs were high versus any immediate reward.

There are strong cognitive roots for the predictable surprises leading to significant harm. Whether positive illusions, overly discounting the future, fear of regret, or a bias to the status quo, there are strong reasons for not seeing the problems in front of us. The biases of the individual are compounded by institutional failures. Firms work in silos, secrecy, and with selective attention. Organizations often suffer from poor learning and special interests.

Bozeman and Watkins form a solution through following a simple three part model of recognition, prioritization, and mobilization. It is a little more complex than three simple actions, but the framework allows for a way to deal with expected issues as they arise. It seems like to can be effective with any information problem. A rules-based system can cut through organizational dysfunction and allow for quicker decisions. A systematic model could apply this framework in a manner that is much quicker than most organizations. Get ready and don't be surprised.