Macro Micro Polarity Management
As discussed above, the flux between immediate visible risks and longer term fragilities presents a perpetual challenge. It’s not a problem that can be solved with better statistical models. Indeed, better data and more precise analytics can lead to overconfidence. This was part of the problem in the subprime crisis (“we were busy looking at sand corns through a microscope when the tsunami hit” recalled a bank risk manager). This is a classic polarity management challenge. Polarities are interdependent opposites which power all complex systems. Barry Johnson’s seminal “Polarity Management: Identifying and Managing Unsolvable Problems” (1996) is an excellent primer.
As you read the pairs below, consider which requires greater attention at this point in the current market cycle:
1. Potential vs. Visible
2. Long term vs. Short term
3. Top-down vs. Bottom-up
4. Strategic vs. Tactical
5. Qualitative vs. Quantitative
6. Risk vs. Return
While we may have individual preferences, it’s important to recognize that each polarity has both positive and negative attributes.
• For example, a focus on Potential risk allows investors to better prepare for extreme tail risks. And yet over-focus on Potential risk can lead to excessive risk aversion and failure to prioritize immediate needs.
• On the other hand, a focus on visible risk allows investors to manage risks that matter now, and to be nimble and take advantage of short term opportunities. Yet over focus on visible risk can result in myopia and underestimation of structural risks.
Well managed polarities maximize positive attributes and minimize negative ones, sparking a virtuous cycle. Polarities naturally move from the upside to the downside of a polarity, and then to the upside and downside of the opposite polarity, and so on. Poorly managed polarities (e. g., too much focus on one polarity) cause a downward spiral. Appropriate timing varies by process, and according to changing circumstances. The key to managing polarities well is to act on early warning signals that suggest pivoting to the opposite polarity. This cycle illustrated in Fig. 12.
Polarity management is a core life practice. As individuals, we can only see one perspective at a time, so we must keep changing perspectives to better perceive and adapt to our dynamic and multi-faceted world. Indeed, according to developmental psychology, the ability to take different perspectives is central to learning and growth.
From an organizational perspective, the ability to shift perspectives is core to an adaptive risk culture which continually sources new scenarios, while quickly honing in on emerging risks.
As a practical current example, we might consider the monitoring of a potential China Hard Landing scenario (Pivot Capital 2011).
1. Macro fault lines include credit dependent growth, a real estate bubble, counterparty defaults, rising bank NPLs, reliance on manufacturing and export, slowing economic growth, as well as social instability due to rural poverty and the rising gap between rich and poor, corruption, and repressive government policies.
2. From a Micro perspective, we consider key market factors which correlate to an emerging scenario (e. g., Chinese rates & bonds, equities, industrial commodities). Our aim is to build Stress Indices with high correlation to specific scenarios. In addition to monitoring emerging risk, Stress Indices could be used for hedging or insurance (e. g., purchase 1 year 95 put protection for China Hard Landing).
Just as in our Financial Meltdown scenario, we would plot a time series of our China Hard Landing Stress Index (or Indices, as multiple variants are possible) and hone in on outliers and escalating volatility.