We like to think we can see the future, but it ain’t necessarily so. Hedging strategies can deal with uncertainty rather better. But a resilient approach to managing a family business works best of all.
In his latest blog, Howard Marks, co-founder of credit manager Oak Tree Capital, tells of Morgan Housel of Collaborative Fund, a venture capital specialist, who opted to ski out of bounds with two friends when they were in their teens.
We can do so by recognising that they inevitably will occur, and by making our portfolios more cautious when economic developments and investor behaviour render markets more vulnerable to damage from untoward events
The day started fine. After lunch, Housel chose not to ski, for whatever reason. But his friends set off, as planned. And their lives were claimed soon after, by a freak avalanche.
Housel has now been inspired to argue there are three aspects to risk management. One considers the odds. Another checks the averages. The third dwells on the impact of a low-probability, but high impact, tail-risk event.
On their ski trip, Housel and his friends knew, by the law of averages, there was a chance of getting caught when going off-piste. They knew the odds were in favour of them getting punished if this was the case. But none of them paid attention to the tail risk of getting hit by an avalanche.
Investors spend their lives calculating the odds and the averages because they produce the illusion of certainty. They gloss over tail-risks because they are as unlikely, as they are uncomfortable.
Housel thinks otherwise: “They’re all that matter. They’re all you should focus on. We spent the last decade debating whether economic risk meant the Federal Reserve set interest rates at 0.25% or 0.5%. Then 36 million people lost their jobs in two months because of a virus. It’s absurd.”
Howard Marks says we rely on past experience to make forecasts because that is the evidence to hand. But forecasts go wrong when complex social interactions push events the wrong way. They blow up when tail risks come along, along with a variety of after-shocks.
The best forecaster ends up being no more than the best guesser, as Cicero once said. And, quite often, not even that. According to Howard Marks investors need to deal with tail-risk events as a matter of routine.
“We can do so by recognising that they inevitably will occur, and by making our portfolios more cautious when economic developments and investor behaviour render markets more vulnerable to damage from untoward events.”
Strategist Nassim Nicholas Taleb, author of The Black Swan, argues investors should have a portfolio weighting of at least 10% in option strategies to protect against tail risks. In the first quarter, option strategies like these returned 57%, according to data provider Eurekahedge.
However, family offices need to be aware it can cost nearly 3.5% a year to keep the option positions. Asset manager Verdad reckons short positions on the S&P 500 index and long positions in US Treasuries can be a better bet for investors who lack timing skills.
Family offices need to deal with unexpected events in a different way, closer to the Howard Marks approach. In her book “Uncharted: How to Map the Future Together”, Margaret Heffernan says too much time, effort and anxiety is wasted in pointless attempts to forecast the future. In her view, talent, discussion, trial and error are better tools to build a business.
Amadeo Giannini served the immigrant community to build Bank of America. Henri Nestlé’s milk-based products became a Swiss food combine. Bill Gates with Microsoft sold his software so cheaply no one could compete. All three have evolved into mainstream companies under new management.
The resilience of their original business model developed out of the successful application of ideas. Not a single economic forecast anticipated their success. But each business has dealt with a succession of tail-risk events
The current owners of family businesses, have just as much to lose, in terms of cash and reputation, if things go wrong. They may lack the insight of their founders.
But their caution and sound finances make them resilient.
In performance data put together for Family Capital, PwC has found that shares in listed French (see chart below) and German family businesses have consistently beaten the rest of the market, over time.
There is no room for complacency. The performance of US family businesses has started to lag large technology stocks over the last three years. A new generation of founder-led businesses by the likes of Jeff Bezos and Elon Musk are putting down their markers for the future.
Caution will count in favour of long-standing businesses. But family businesses also need to adapt to changing business conditions, wherever they are based. Not least because tail- risk events are just as capable of producing seismic tech disruption as a freak avalanche.