Streamline Training & Documentation: Coping with Uncertainty

Saturday, January 23, 2010

Coping with Uncertainty

The Winter 2010 issue of the MIT Sloan Management Review has an excellent article addressing the issue of how businesses can best cope with uncertainty.

Spyros Makridakis (INSEAD), Robin Hogarth (Universitat Pompeu Fabra, Barcelona), and Anil Gaba (INSEAD) note that there are two types of uncertainty:

Uncertainty concerning events whose probability distribution is known

Uncertainty concerning events whose probability distribution cannot be known

The authors note that even in the case of events with a known probability distribution, it is generally impossible to know when a low probability event will occur. The situation is even more nebulous for the second type of uncertainty, since even the frequencies of possible events are unknown.

Since forecasting in an uncertain world leaves the key question, "When will the Big One hit?" unanswered, the authors argue that a business should de-emphasize forecasting exercises and instead prepare for the future by developing plans for handling various scenarios, including quite extreme, if rare, situations.

The authors recommend a technique they call "future-perfect thinking." They offer this example:

Assume you’re the CEO of a major airline, and in order to formulate your corporate strategy, you need to forecast oil prices for the next five years.

First, imagine that five years have already passed. You’re now able to look back on what happened over that period. It turns out that oil prices have been quite low and stable over the “past” five years, which was a great benefit to the airline (and your career). However, instead of just enjoying that imaginary good luck, explain — or tell the story of — how such favorable circumstances came about. What were the particular economic and geopolitical events that contributed to the low, stable oil prices?

Now, take a second trip forward five years on the time machine. This time, however, when you look back at oil prices, you are exasperated. All you see is mayhem: a period of steep and highly volatile prices that made running the airline almost impossible. Once again, explain what happened. What were the particular economic and geopolitical events that led to that painful scenario?

If you do that kind of exercise a few times, focusing on the realms of your own experience, you’ll start to develop a feeling for different futures and the fact that they are all plausible. ... [T]hough there is no formal technique for converting plausibility into probability, you can use your new insights to develop appropriate risk protection strategies. That is the essence of future-perfect thinking. It involves harnessing the clarity of hindsight to develop more vivid pictures of the future.

The affinity of future-perfect thinking to scenario planning is apparent.

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Labels: Risk management, Strategy

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