I have noticed, in topic areas ranging from health to finance, that systems optimized for performance often have a higher mortality rate than those optimized for risk.
Following What Works
I first noticed this when I built allocation models and econometric models for a previous employer back in my finance days.
I had spent a few years working on various models that would scan a number of different strategies, and move the portfolio between them depending on what was working in the current economic environment. This is what is known as “chasing returns” in the investment world. These systems always had great returns. However, their volatility had gut-wrenching dips that would scare any sane investor. Given enough time, they usually rebuilt their equity; but who is really going to sit through a 60% loss in wealth?
I tried including macro economic variables in order to understand the “bigger picture”. While this helped, it didn’t solve the problem. No matter what I tried, the volatility was wild, and the number of portfolios that ended up bankrupt was too high to make the strategies implementable.
Tiger Woods offers some insight
I was listening to an interview by Tiger Woods one day that offered an insight into a different approach.
He stated something along the lines of
My goal isn’t to get a great shot or hole. Instead I try not to lose too bad on any single hole. This way, when I do get a great shot, it puts me ahead rather than catches me up.
There are a number of wonderful implications in the above quote. The main one for me was a focus on risk management rather than performance.
Until now I had always focused on return. What if I focused on risk instead?
Turning Modern Portfolio Theory on its head
The first thing I did was take something known as MPT and change it completely around. In short, you can find the optimal portfolio allocation by understanding the risk and the correlation of different asset classes.
What if instead, I ignored return, and only focused on optimizing risk?
The craziest thing happened, these portfolio lines grew steadily through market expansions and crashes. They enjoyed great upside while suffering very little down side. This created in me a personal motto that I explored in finance for the next 5 years, and throughout life and business every since:
If you take care of risk, the returns will take care of themselves.
Optimizing for risk and leaving performance alone
Unfortunately we live in a culture where performance reigns supreme.
Not only are portfolios measured by their returns, but…
Diets are measured by the increase in various athletic tests.
People are measured by their output and productivity.
Perhaps worst of all, companies are measured by how fast they reach a revenue number or how quickly they get funded.
The focus on performance rather than sustainability and risk creates a craze around racing to the top, often ending in lower accounts of long-term success.
The Ketogenic diet offers some very real athletic benefits and fat loss results. However, it also offers a [higher mortality rate] given its [increased animal protein consumption].
As found in my experience in modeling portfolios, allocation models, and switching algorithms, focusing on returns ended in more volatile and riskier portfolios than focusing on risk mitigation.
In business, too much funding can create a targeted strategy based on the [needs of the investor] (and [the need for subsequent investors]) that may be contrary to what is good for the business long term.
Focus on the risks of your business
By focusing on the risks of your business instead of its performance, you will line up with a very real principle that we see everywhere:
optimizing for performance has a higher mortality rate than optimizing for sustainability and risk mitigation.
This can look very different for companies in various industries, but the principle applies broadly and can be used as a foundational piece of any strategy.
Instead of relying on a star performer in your business, focus energy on documenting proven strategies and implement cross training. A strategy built on what one or two people are doing is extremely fragile. It may outperform for a while, but it is higher risk and will eventually stop.
It is better to build a company on a process that can be documented and shared and thus scaled to as many people as needed. A company that can grow consistently and predictably is much more sustainable than a performance based company utilizing a star hire.
They are fun to work with, and can bring excitement to your company; however, they are at the performance end of the spectrum in terms of strategy
Of course, this is only one of many examples.
Whether it is the people you hire, the metrics you employ, or the strategies that you devise, do your best focus on sustainability and risk mitigation. Ask yourself:
- Does this move us towards relying on an anomaly or a system?
- Can this be repeated at will?
- Does this increase our reliance on a software, a law, a person, etc, and thus increase our risk?
- Will this work in 10 years?
- Will improvements to the system help us or hurt us if we use this?