What are Grey Swans and Gray Rhino’s in the world of risk management?
Gray Swans: Before speaking about Grey Swans let me bring up their celebrity cousin, the Black Swan. Black Swans have been immortalized in risk management by Naseem Taleb’s classic book and are now part of the lexicon of the risk manager. Black Swans are characterized by 3 features as defined by Taleb – 1) they are extremely rare events; (2) they have a drastic impact and most importantly (3) they cannot be predicted but can only be explained after the event has occurred. In contrast, Gray Swans are used to describe events that are possible but not considered likely to happen and that have extremely significant impact. Specifically, the likelihood of a Gray Swan event occurring is more than a Black Swan event and crucially Gray Swans can be predicted impact unlike a Black Swan. In other words, Gray Swans are the Known Unknowns while Black Swans are Unknown Unknowns; Gray Swans lie in the tails of the distribution while Black Swans lie outside the distribution (and so cannot be predicted).
The insurance company, Aon has partnered with consulting firm, Pentland Analytics and published a fascinating paper containing study of 300 Gray Swan events over 40 years. Their key observation from analyzing these 300 Gray Sawn events has been that;
- we ignore events with limited data and low probability but high impact
- impact of Gray Swan events is substantial – over 50% of shareholder value was destroyed in 10% of the cases
- Recovering from Gray Swan events requires focused attention and investment
Pentland Analytics has further studied the impact of 300 Gray Swan events in terms of stock price and notes that failures in governance and poor business practices are the most damaging; on average, these crises destroy almost 15% of shareholder value over the following year. Governance/Business Practices are also the most common causes (36%) of Gray Swan events followed by Product/Service Failures (19%).
Outside of corporate crisis, the paper lists the following as examples of Gray Swan events and cautions not to think of them as Black Swan events because they were not inconceivable and each of them had prior indications (with low probability) of them occurring.
Firms cannot hedge against Black Swan events because they are unpredictable however they can hedge and build resilience against Gray Swan events. The paper offers leadership lessons on how to recover from crisis’s and the response of management makes a key difference in how much shareholder value is lost and how soon it recovers. Key aspects of the right response include;
- Preparedness – commitment to loss prevention and risk management
- Leadership – visible and proactive leadership from CEO
- Communication – quick and accurate to be effective
- Action – rapid, specific and credible
- Change – commitment to change
Gray Rhino’s: And finally the Gray Rhino, this is the Elephant/Gorilla in the room and is an event that is highly probable, has high impact but crucially is a neglected threat. The term was popularized by Michele Wucker in her 2016 book who also runs a blog of the same title. In her own words, a Gray Rhino is the “massive two-ton thing with its horn pointed at you, stomping the ground and getting ready to charge — and, most important, giving you the chance to act“. She does make a pertinent point that it would be be a better use of our time to avoid getting run over by the charging Rhino rather than retroactively spotting a Black Swan.
Michele also publishes an annual list of the top Gray Rhino’s every year and for 2020 the top Gray Rhino’s charging down the landscape are all uncomfortably familiar too us;
- Economic Fragility
- Geo-political and Domestic Uncertainty
- Climate Change
- Cyber and Digital Risk
- Supply Chain Risks
The difference between a Gray Swan and the Gray Rhino is the higher likelihood a Gray Rhino event however this could be subjective. As an example, Covid 19 has been termed as a Gray Swan (low likelihood but high impact) in the paper by Aon and has been termed a Gray Rhino (highly likely) by the Michelle Wucker in an op-ed published in Washington Post last year. The other difference between these two labels is that the Gray Swan is ignored due to lower likelihood while the Gray Rhino’s is ignored even though it maybe be an imminent threat.
The punchline – the reason why we ignore the Gray Rhino charging down the road or the uncommon Gray Swan is due to our cognitive and emotional biases. We avoid the hard facts and are sometimes willfully blind to the red flags because it is not common (Gray Swan) or points to an uncomfortable truth (Gray Rhino).