Smooth-sailing fallacy

One benefit of working for a European headquartered company is things slow down enough in August that I can start to catch up on reading. I was particularly intrigued by a short June 2009 McKinsey Quarterly article entitled “Management lessons from the financial crisis” in which UCLA business professor Richard Rumelt coins the term “smooth sailing fallacy”.

This smooth-sailing fallacy arises when we mistake a measure for reality. Competent management always looks deeper than the numbers, deeper than the current measures. Incompetent management just focuses on the metrics, on the body count, on quarterly earnings – or on GDP growth or the consumer price index. And that’s how we get into these troubles. We really have to think about the redesign of a lot of institutions and doctrines around measurement. This lesson is fundamental: you cannot manage by just looking at the results meter.

Although he doesn’t use the same language, Rumelt seemingly shares my concerns with the preponderance of metrics, especially ones that measure activities. Our obsessions with red/yellow/green dashboards have caused us to lose sight of the business outcomes we are trying to achieve.

Rumelt uses the classic story of the Hindenburg to provide a memorable analogy. In terms of their length and volume, the Hindenburg Zeppelins were the largest aircraft ever to fly; longer than three Boeing 747s placed end-to-end and almost the same length as the Titanic. With more than 600 successful flights, they were also considered safe and the future of air travel.

No matter what metrics you used, it would have been nearly impossible to quantify the risk the passengers took or to predict the fire that caused the Hindenburg to burn to the ground in May 1937. In Rumelt’s words:

The fallacy is the idea that you can predict disaster risk by looking at the bumps and wiggles in current results. […] To see the disaster coming, you had to have looked beyond the data about flight bumpiness— beyond the professionalism of the staff—and really think, “Does it make any sense to have people riding in a gondola, strapped to a giant sack of flammable hydrogen gas?” […] What happened to the Hindenburg that night was not a surprisingly large bump. It was a design flaw.

The recent financial meltdown is nearly as spectacular as the Hindenburg disaster. The outcome couldn’t have been predicted by looking at balance sheets, by tracking the consumer price index (CPI), or any individual measure. The problem was a design flaw. We were putting money into a variety of credit and asset structures that were nearly impossible for anyone to explain and that the rating agencies didn’t really understand. In essence, we had the entire economy riding in a gondola, strapped to a giant sack of flammable hydrogen gas.

It’s a wonder the explosion wasn’t even bigger.

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One Response to Smooth-sailing fallacy

  1. Thomas August 9, 2009 at 8:54 pm #

    Thanks for this Jonathan.

    I read Taleb’s Black Swan several years ago. Our mutual friend James Governor gave it to me. It made me rethink my views on risk management, and indeed of broader economics.

    Over the past few years the term “black swan” itself has almost become a dashboard indicator. The Hindenburg gives me a strong picture as a fresh alternative to all those flocks of black swans.

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