On Economic Volatility

April 3rd, 2006

Incredibly, I have occasionally heard people say economic volatility doesn’t effect them. If I attribute the more thoughtful comments of others to what lies behind that terse and defensive statement, I might characterize the comments this way:

– It’s never effected me
– I have enough wealth/sales/low costs to weather storms
– I can do nothing about it.

The first one is patently absurd; if this claim is anything other than brush-off, woe betide that owner’s constituents, they will as sure as night follows day find themselves deprived of money/goods/jobs sooner than anyone expects. Of course, I would find little consolation in the idea that someone is brushing off the idea, either. Shooting the messenger has little benefit beyond a fleeting sense of revenge.

The second betrays a fortress mentality. In a sense, it places all wealth in the service of defense and not in the service of capitalizing further wealth creation. Because it is in the front lines, it is also entirely in play—-not unlike like using printed dollar bills to build a house rather than use their purchasing power to construct a more effective dwelling.

The third used to be true, at least for small business. Furthermore, if no one can do anything about it, the result resembles stability. All boats rise and fall on the same tide.

Of course, big business has had the resources to mine, analyze, and implement the data for years, and the scope to have those expensive efforts pay out. It may explain why small business, in most industries, has been ceding ground to large for decades.

The trend is reversible. The impact of technology on all areas formerly the exclusive province of big business is so pervasive and observed that to point it out feels passé. Consider the music industry; consider ebay. In the last 10 years reams of important data have become accessible to very small businesses; the only thing that is surprising is how many of them don’t know it. Or, having no experience in that realm (see above), that many extrapolate the conclusion that the data is not relevant.

Economic volatility is the label we place on events external to an individual business that profoundly affect what it does or is. It was pushed to the fore for Tom Walker, Sr. years ago by the simple observation that businesses could have a good product and good internal management and still crash and burn with barely a moment’s notice. The trigger point was always something from the outside. That trigger point invariably exploited (sorry for the anthropomorphism) some hitherto non-threatening weakness in the firm, and on that basis the ever-present cadre of experts blame the firm for permitting the weakness, now so obviously a serious management deficiency, to persist.

On this basis, as technology has allowed—-and this is certainly its downside—-we have seen a proliferation of internal controls and systems, with the attendant proliferation of people who run them and the paper and incoherent databases they produce. Yet none of this addresses the issue. It is the civilian equivalent of the general who is still fighting the last battle.

The cure may be worse than the disease. The practical effect of these controls is to throttle entrepreneurship, which is the small firm’s only economic play, while actually do nothing to navigate through or around these externally-driven events.

It is the nature of a firm, or a fortress, or an army, to have chinks in their armor, and the thing that most effectively exposes those vulnerabilities to others is to stay in one place and try to patch them.

Since no man is an island, therefore neither is an individual firm. There are things that truly don’t touch a firm directly, but many have a powerful impact on key constituents.

Still, is economic volatility such a pressing issue? When it comes to gaining a competitive advantage, it will become so…which means it already is. In our experience, the effects of misdiagnosing or being entirely oblivious to economic volatility are:

1) Owners buy when they should sell, and sell when they should buy.
2) Expansions are embarked on at the wrong time.
3) Owners speculate in tradable commodities without knowing it.
4) Operations are ruined by effecting internal solutions to problems that came from outside the firm.
5) Internal problems are missed because favorable external conditions mask them.
6) Accumulated wealth is used to hedge against future uncertainty, resulting in one’s entire net worth being in play, low return on assets, and a de facto semi-retired status…all of which is invisible to the owner.

These aren’t absolute measures, but rather errors made by degree. They arise from the personal limitations of

– experience
– bias
– memory
– data
– ability to handle complex interdependent variables.

People do not always get these judgments absolutely wrong–although educated, intelligent people do that often enough—-but decisions end up being sub optimal, for the set of reasons above, leading to one or more of the consequences above.

But these limitations of individual human knowledge are readily resolved by resorting to mechanisms for price discovery, some of which have 150 year careers (and counting), and by statistical techniques, many of which are at least 200 years old.

In brief, then, the method of practical application to small business is economics, statistics, and strategy. If those topics weren’t a sufficient turn-off for most, the prospect of using futures to hedge will turn away the rest. The good news is that for those willing to tackle what everyone else deems excessively theoretical, doctrinaire, or just plain difficult, the chance to gain an advantage is large.