Adapted from Stalking the Black Swan: Research and Decision Making in a World of Extreme Volatility by Kenneth A. Posner. Copyright © 2010 Columbia University Press. Used by arrangement with Columbia University Press. All rights reserved.

David Stalking the Black Swan

By Kenneth A. Posner

The capital markets crash of 2008 has taught more people to appreciate the idea of the Black Swan. Popularized by Nassim Nicholas Taleb, the Black Swan refers to a highly improbable event that seemingly could not have been anticipated by extrapolating from past data. In the markets, Black Swan events are marked by sudden shifts in the level of volatility affecting stocks, sectors, and sometimes the entire economy, producing price shocks of multiple standard deviations, at least as measured by the sense of risk prevailing before the storm.

The idea of the Black Swan should not be reserved for infrequent global shocks; rather, Black Swans occur at different scales all the time. Many now associate the concept with the recent downturn, widely regarded as the most severe since World War II, the kind of shock we all hope is infrequent. But there are plenty of smaller, more mundane swans, whipsawing individual stocks and sectors, even when the rest of the market is calm. These surprises have several sources, including the inherently difficult-to-forecast complexities of the fundamental world, the collective behavior of people in markets, and the feedback effects between fundamentals and markets. One particular source of Black Swans is the "information asymmetry" between investors and managers.

In economic theory, asymmetric information is a term used when one party has more or superior information than another. The better informed have stronger leverage in negotiations. Being on the wrong side of asymmetry is like playing poker with an open hand while your opponent keeps his cards close to the vest.

A wealth of proprietary information gives management teams an advantage in communicating with investors. They can fashion compelling arguments, speak with authority, and refute challenges decisively. To promote their own interests, they may reveal some information and keep other data hidden. Managers often tout their company's successes and downplay disappointments, trying to encourage listeners to extrapolate from the high points to the company's aggregate prospects.

This problem has irked even the most successful investors. For example, while a member of the board of directors of Salomon Brothers, Warren Buffett discovered that he had been taken in by a form of "information rationing": the management team withheld from its directors some of the most important facts about the Treasury auction scandal that nearly scuttled the firm. And information asymmetry is not a challenge just for investors. Any decision maker who relies on managers, agents, analysts, or experts is likely to encounter the problem.

There are broadly two strategies for mitigating information asymmetry. The first involves monitoring a company's message for signs of cognitive dissonance. The second involves crafting interview questions to elicit information with diagnostic power.

Overcoming Information Asymmetry in Interviews
  • Confine the agenda to critical issues
  • Bring specific questions with diagnostic power
  • Ask "how" and "why," not "what"
  • Pay attention to ducked questions and nonanswers
  • Avoid debating your own views
  • When analysts can gain an audience with managers, the proper structuring of questions may help overcome information asymmetry. But that requires preparation. Not only do managers enjoy an information advantage, but also securities laws prevent them from disclosing nonpublic information in private meetings, so analysts cannot ask direct questions about many pressing issues. By encouraging managers to stay "on script," the laws offer a handy excuse to duck inconvenient questions.

    Also, managers do not attain responsible positions unless they are confident, charismatic, and capable of inspiring confidence. During the Internet and technology boom of the late 1990s, some thought that personality and image had become more important in CEOs than business abilities, knowledge, and experience. This sounds crazy, until you remember how stock prices and fundamentals may interact. Promotional skills are indeed important, and this makes interviewing CEOs something of a challenge. The art of interviewing is to maneuver the manager into a spot where she cannot credibly deliver a scripted answer and where even a nonanswer would have diagnostic power for critical issues.

    An example of an effective interviewing strategy involved American Express. In late 2007, I arranged to meet with the executive in charge of the U.S. lending portfolio in order to get information on a critical issue: credit quality. I knew that direct questions about current trends would elicit nothing but scripted answers. Like many big companies, American Express's investor relations officials kept their executives on a tight leash and interrupted the conversation whenever an analyst asked questions about recent trends or forward-looking guidance.

    Credit quality was a critical issue for American Express, not only because of general concerns about the environment in the fall of 2007, but also because the company's loan portfolio had grown much faster than its competitors' in recent years. I thought about how best to formulate a question. The one that ended up working the best: "Given that American Express has grown its credit card portfolio so much faster than the rest of the industry in recent years, can you explain which of the following factors produced that growth: marketing, underwriting, product features, or brand?"

    If the answer was convincing, it would give me confidence in the company's portfolio. A nonanswer would lead me to suspect sloppy underwriting as the reason for fast growth. Truth be told, I worried that I had left myself open to a long-winded discussion of the power of the American Express brand, a fair argument but not new information. To my surprise, the executive paused, took a deep breath, and responded, "We keep asking ourselves that very question."

    Sometimes a well-designed question hits the motherlode. Indeed, credit quality was about to become a serious problem for the company.

    Kenneth A. Posner is a financial services industry analyst and a fifteen-year veteran of Morgan Stanley, where he served as managing director and senior research analyst and where his work received high rankings from Institutional Investor and Greenwich Associates. He earned his MBA from the University of Chicago, Graduate School of Business and holds the Certified Public Accountant, Chartered Financial Analyst, and Financial Risk Manager designations.