on the concept of a frog in the pot
By: Robert Wagner
March 17, 2017
Not nearly as famous as The Boy Who Cried Wolf but there is a short fable I have heard over the years about the frog in the pot. The story tells us about what happens to a frog if you were to drop it into a pot of boiling water... the frog will supposedly jump right out as it's reflexes to danger create an immediate response. However, if you were to put the frog into a pot of cold water, and slowly bring up the temperature to a boil, it will not sense immediate danger and will slowly get cooked.
I did a bit of research to determine whether the story had any scientific basis. My conclusion is that the science behind the story is at best questionable and more likely not technically correct. With that caveat out of the way, I believe the story offers some key insights into some basic behaviors and helps illustrate fundamental ideas about risk.
When something dramatic suddenly changes in our environment, especially if it poses a threat, generally people are pretty well wired to recognize it and have a fighting chance to develop a response. In that case we are like a frog who when sensing the boiling water, reflexively try to jump. Recognizing the risks of sudden and dramatic changes generally is a relatively simpler risk management challenge.
The tougher challenge, and the moral of the frog in the pot story is about the risks of small, incremental change, slowly building up in some key factors of our environment. Complacency can easily set in, small signals can easily be explained away or dismissed, and we slowly get cooked in the pot. One day we wake up and realize something material changed in the surroundings, and it is too late to do anything about it. We look at each other with amazement and can't believe we missed it. Huge changes that take place little by little can often be missed.
Why does this matter when thinking about risks? In my view some of the most important risks in the long term have characteristics that tend to build up little by little incrementally, creating exposures that can suddenly turn bad at some point down the road. When evaluating industries, businesses, or the performance of people in different jobs, we receive data points from many directions on a continuous basis. Much of this data ends up being noise, but some data may point to emerging patterns that could signal a new trend in the environment. The water may be getting a little warmer...
The gradually building up of a significant risk over time can take many forms. Sometimes a new business venture, or opening of a new office is how things get started. First activity is small and limited, likely systems are inadequate to track the details, but as the business is small, the risks are accepted. Over time as the volume and complexity of the activity grows, there may be some periodic scares but ultimately the concerns are met with reassurances, people take a deep breath, and move on to worrying about other things. Eventually some outside factor, a large market price move, a big operational issue, a large customer or supplier default or key personnel departure exposes the underlying buildup of risk, and suddenly the problem becomes crystal clear.
However, this type of risk is not limited to new business ventures. Mature businesses can find themselves wading into risks they don't fully understand. Maybe the traditional business model has come under competitive pressures and new sources of income are being sought out. Perhaps excess cash flows are being reinvested toward diversification rather than being returned to shareholders. Often a series of acquisitions little by little ends up completely transforming a company, at times with significant loss of shareholder value.
Serious accounting problems may develop in a similar fashion. The rules often allow some latitude especially when it comes to valuation of complex long term contracts. In many cases it seems to be very difficult to pinpoint precisely where things went wrong. Maybe the underlying business was starting to falter, and the assumptions got a little bit less conservative. Then next quarter the assumptions had to be stretched a little more, expecting the business would surely recover soon. Eventually when the business does not recover and cash flows do not match reported profits, it is suddenly realized the numbers were wrong all along.
Leverage can follow a similar buildup process. When times are good and debt is relatively cheap, it can be very tempting to borrow a little more... the process can be maintained for quite a while for an individual company, industries overall, and entire countries in aggregate. The frog is slowly cooking in the pot without realizing what's happening to him, until creditors suddenly sour on the risk, sentiment changes, and everyone wakes up to the unsustainable nature of what's happened.
Of course, after listing some of these possible scenarios, the obvious question becomes: what if anything can be done about gradual build-up of dangerous risk, how can it be identified early enough, and how can decision makers be convinced to act.
I do not profess to have a perfect answer to this question, as my own thinking about this type of risk continues to evolve. However, I will share my thoughts on what may be some ways to approach the problem.
One important idea in my view is to make sure to stop periodically, get one's head out of the day to day, and think critically about what's happening in an organization. What are the main activities, and how are they changing? If the frog had a thermometer and was able to understand what it represented, it would help it avoid getting close to the boiling point. How can we design the equivalent of a thermometer to fit the specific context (business, non-profit, government, etc,) to help identify accumulating risks? The metrics could be tailored based on the context and the metrics themselves likely need to be revised over time.
Some metrics would be qualitative, such as: how is the culture of the organization changing (or, any acquisitions where cultural fit is a potential problem), who are the key decison-makers, how transparent are they and what's their long term track record? How good are the systems for tracking activity in detail, not just locally or by business unit, but across the organization? What is the quality of the risk management systems, processes, and team?
Other metrics would include quantitative factors such as: what are the large notional exposures and how are they changing? What is the complexity of transactions, their volume, geographic or customer concentration, etc.
These metrics over time may help create the tools which enable one to gain a perspective approaching that of an outsider coming in for the first time. It is not easy to get an outsider's objective perspective especially about something one is very closely involved with. It would be great to be able to take periodic sabbaticals and come back with a fresh set of eyes but in most professions that is not a realistic expectation. Periodically bringing in experienced people from the outside may also be helpful in the diagnostics of quietly accumulating risks. Often struggling businesses have to change out most of their management teams in order to get this fresh start and objective look at the reality without the baggages or biases of the past.
In summary, how does one avoid being the frog in the pot slowly waiting to be boiled? The first step is to recognize the possibility that this may be happening, and keep an open mind to carefully think about those factors that maybe ever so slowly changing around us. Take a look around and ask how things compare to a year or two ago? Has anything material changed in a big way, and is it properly understood? Are we at risk of waking up one day and realizing suddenly that our environment completely changed? In future notes, I will offer some more detailed thoughts on the metrics and thought process I find helpful to systematically answer these questions.