In late 1880’s the celebrated (is that the right word?) arms dealer and speculator Sir Basil Zarahoff pulled off one of his greatest coups – he managed to sell the same submarine designs on an exclusive basis, to both Greece and Turkey convincing the bitter rivals it would ensure their naval superiority over one other. Just to add into the mix he worked the same trick with the Russian government convincing them the submarines could ensure Russian command of the Black Sea and the Eastern Mediterranean. In the event all the submarines proved to be very inferior, and none saw active service, though Zarahoff of course made huge selling commissions.
This is the classic example of the middleman being a big winner and with limited risk. In this case the middleman actually created the market for the arms. Clearly Zarahoff understood 1970s marketing guru David Abbott’s maxim; “There may be a gap in the market, but is there a market in the gap?”
This story set me thinking about how we play different roles in life (and by extension) markets, and why the distribution curve might be a nice guide on occasions. In this blog I’m not delving into the world of fat tails et al., but rather a general look at how “averages” can help and hinder. We probably become aware of distributions very young in life, perhaps in our class one kid is very tall and another very short with the rest of us somewhere in the middle, just being average. Most of us seem to be average at most things most of the time, well of course we must be!
The media and financial markets are interested in extremes, “Man bites Dog” and “Crash wipes off billions of dollars” are news. This makes sense (despite the sensationalism) as most new information is found in the tails of a distribution not in the data clinging to the average. We may dream of being in the tail, as a rock star, world class athlete, tycoon, or captain of industry but we are resigned to failure in such fields, as we are still stubbornly just average. On occasions an exceptional person will try hard to be average, the field of espionage or fraud usually calls for those with unusual talents but their stock in trade method is to be “Hidden in plain sight”.
Thinking in this simple way can help in our understanding of risk. Too much risk management ends up being just risk measurement, whereas the key to success is in identifying risk, in particular new risks. This is a dynamic approach, whereas risk measurement is often static if not just a formulaic box ticking exercise. By questioning constantly and thinking about new information and whether its unusual or doesn’t ring true, is the real skill in risk management. We need to watch the tails for new information, whilst still keeping an eye on the average group for any sudden unexpected behaviour that reveals hidden deeper information that is being concealed.