The Signs Are There: Recognizing and Preparing for Gray Swans

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November 10, 2021


Overview

World War I, the stock market crash of 1987 and the development of the internet. These events have all had a significant impact on the world. So much so that author Nassim Nicholas Taleb popularized a term for this kind of rare, unprecedented, intrinsically unpredictable event: “black swan.

But what about the “gray swan?”

A gray swan is an event that is still rare but can be anticipated and managed. Examples might include the current COVID-19 pandemic, 2005’s Hurricane Katrina or the 2008 financial collapse.

But while gray swans can be anticipated, they’re too often ignored. They can be overlooked simply because of our natural tendency to ignore events that are too awful to contemplate or too difficult to address. Ignoring these unlikely perils is a mistake, however — their impacts can be significant. Inadequate preparation for a gray swan can lead to a reputation crisis. In more than 10 percent of reputation crises, 50 percent of shareholder value is destroyed.

“Gray swan events have a major impact that can be positive or negative,” says Dr. Deborah Pretty, founder of Pentland Analytics. “They’re rare, but they’re not inconceivable, so you can prepare for them. These are events that affect the future trajectory of our companies. But crucially, there’s something we can do about it because we can anticipate them.”

In Depth

As detailed in Aon and Pentland Analytics’ report, “Respecting the Gray Swan,” a gray swan sits between its rare, and impossible to model, black cousin and a white swan event — those more run-of-the-mill risks that organizations are well-accustomed to managing.

It’s therefore possible to analyze and prepare for a gray swan event, says Pretty. “There is some data. And there is imagination. You just can’t use your standard arsenal of statistical modeling techniques to address them.”

Recognizing the Gray Swan

On closer examination, many events initially considered black swans were in fact gray swans that were anticipated:

  • Years before the 2008 financial crisis, warnings of the risk accumulating in mortgage-backed securities and collateralized debt obligations began to emerge. In fact, in 2003, Warren Buffet referred to complex derivatives as “financial instruments of mass destruction.”
  • Three years before the 2011 Fukushima Daichi nuclear power plant disaster, the plant’s operator, Tokyo Electric Power Company, rejected a report estimating the tsunami threat to the plant as “unrealistic.”
  • There were numerous warnings before the current COVID-19 pandemic of the likelihood of a global pandemic with potentially serious health and economic consequences. The past 20 years had seen many examples of epidemic- and pandemic-prone diseases, and in 2019 the World Health Organization warned that the world wasn’t prepared for a pandemic.
  • Looking forward, physical damage to key infrastructure from a cyber attack is an example of a potential future gray swan.

    Why Gray Swans Are Overlooked

    For business leaders, natural human frailties often stand in the way of preparing for possible gray swans. Processing probabilities can be difficult. And it’s natural to prefer consensus over conflict.

    “We routinely underestimate the low probability, high severity event,” says Pretty. “This is due to many perfectly natural and human cognitive biases.”

    The result is that too often these biases prevent business leaders from addressing gray swans:

  • Ambiguity effect — A preference for options with known probabilities
  • Normalcy bias — Underestimating the likelihood and severity of disaster scenarios
  • Optimism bias — Underestimating the likelihood of being directly affected
  • Ostrich effect — Ignoring negative information to avoid the anxiety of decision making
  • Herd instinct — Aligning with the behavior of the larger group to avoid conflict
  • Status quo bias — A preference to continue as is rather than risk loss
  • Analyzing the Gray Swan

    While there are data available on gray swans, they tend to be limited or offer a number of different meanings. So, business leaders looking to prepare for their impact must go beyond the modeling used for more commonplace perils.

    “The data can be ambiguous; It can be quite complex and it can be contradictory,” says Pretty. “It can be difficult to interpret, but it’s not impossible.”

    One possible approach for leaders evaluating potential gray swans would be combining quantitative data with expert opinion to develop a framework for managing this particular risk, Pretty says.

    “You can’t rely on standard statistical models that use loads of data and have a great sample size, but nor would you despair and say, ‘There’s no data, I can’t do anything,’” Pretty says. “Instead, you’d say, ‘Let’s use what data we have, and let’s speak to some experts.’”

    Faced with ambiguous data, leaders would be wise to seek more than one expert opinion as they develop a risk management framework for a gray swan.

    “If everyone in the room looks at a problem in the same way, has the same cultural and educational background and basically thinks similarly, it’s not going to be a productive exercise,” says Pretty. “But if you have a group that looks at this complex, contradictory, ambiguous data and everyone’s coming at it from different backgrounds, different experiences and thinking differently, that could be very productive.”

    The Keys to Addressing Gray Swans

    Regardless of how expected or unexpected a risk might be, organizations will benefit in times of crisis from a culture of resilience that includes strong leadership and preparation. As they confront gray swans, the keys to addressing them successfully are preparation, leadership, communication, action and change, says Pretty.

    Before an event, crisis management training and a top-down effort to foster effective communications and create a culture of resilience are essential.

    During an event, leadership and effective communication that is backed up with credible action are critical to recovering and protecting the organization.

    After the event, once the dust has settled, organizations must commit to making the changes necessary to reduce the risks posed by similar future gray swans.

    Pushing Boundaries to Prepare for Gray Swans

    As organizations look to identify gray swans and address their risks, they can benefit from creating a diverse group to assess potential risks. It’s also important to create an environment that fosters bringing potential bad news to upper management.

    “Being OK with escalating bad news and challenging assumptions is an important cultural aspect,” says Pretty. “If operations look and feel too comfortable, then it probably is too good to be true. So it’s about being comfortable with being uncomfortable.”

    “To prepare for gray swans, it’s important to push our boundaries as individuals, but particularly as groups, because groupthink and peer pressure to agree and form consensus flies in the face of some of this analysis,” says Pretty. “Having consensus is wonderful in a team and in a company, but as we look for gray swans it’s also constructive to challenge prevailing views.”