Personal Diversification

Markowitz/Fama portfolio theory is shaky in its assumptions and reliance 0n estimating parameters that are difficult to fully understand (especially with tail events), but one insight is useful – diversification. However, blind diversification is foolish and securities are really their own form of derivative – a derivative of the business operation itself. You can, however, diversify cash flows that have correlations that are easier to estimate than asset prices, at least heuristically. However, there is little need to over-analyze or “forecast”  – I advocate a loss limit on any new venture and conservative testing methods of a change in the business model or decision process. In many cases, common sense and intuition can drive your diversification strategy.

For example, I tutor and run a vending route, and also run a frozen drink machine rental company, Atlanta Freeze. My cash flows are diversified in that downsides to one does not hurt the state of another, and they sometimes share the upside. For example, vending is fairly steady overall, but many individual locations are very seasonal. The business self-diversifies around the seasonality by having a certain selection of clients/locations.

Tutoring and AF are almost inversely seasonal – the colder months tend to be when students are in school and need math or physics lessons, and the frozen drink rental business has far higher sales in warmer months, when people tend to party or vacation more often. If cash flow from one source diminishes, often the other will pick up the slack. On top of this, gains can be made from transportation economies of scale, i.e. stopping at a vending machine or two on the way back from tutoring (and locating new machines alone usual tutoring routes) to optimize profit per gas mile across jobs. An additional gain from networking is available – clients in one business/profession that have benefited from my work are more likely to use another product/service through me.

I will be writing a review on Nassim Taleb’s new book, “Antifragile”< but I want to process my thoughts on the book a bit in order that I may write a comprehensive review. Many reviewers tend to focus on one aspect of the book as it relates to their viewpoint (i.e. medicine, business, politics) but the book is really a much deeper concept about the properties of systems and interactions. It is essentially the decentralizationists “manifesto” at this point and I have held this view in an incoherently constructed form until this book, so I have much more to say on it than most and will be writing a lengthy review.The following is based on some of the concepts from this book.

This diversification of cash flow essentially makes the entrepreneur resistant to large shocks, gives him information and should ideally be constructed to be dynamic with decision heuristics rather than strict business plans and guidelines. In contrast, the “all-in” entrepreneur (often a “tech” start-up that faces very unique parameters and highly asymmetric payoffs) and the 9-5 worker are more fragile – the “all-in” entrepreneur suffers both from early instability and risk of total failure (as subsequent losing of life savings), and the 9-5 working is very stable until you lose your job, then it is again a total loss of all income streams less unemployment pay – a blowup. Now, the “all-in” entrepreneur is usually the one that has the largest positive payoffs, but the problem is that people tend to start with too little backup/cushion capital. Learn business at a level where you can tinker a bit and perhaps integrate concepts and ventures so that negative shocks are offset but you can gain positive emergent properties across ventures.

Personal cash flow and the non-linearity of time=money

The fiscal cliff continues to loom and panic has set in. While unemployment is steady at 7.9%, real median wages have been falling (and the distribution of real wage losses are heavily skew right). Much of this is a function of the structure of the economy. For most employers, well developed, specialized skills are in greater supply than demand, so companies are able to be fastidious and  will usually not hire based on potential. No need for long term investment in training; just hire someone with the skills in the present that can be thrown right into the field.

Like most strategies in the corporate world, this makes significant short term sense at the sacrifice of long term benefits. But that is not the point of this post. This is a reality that no institution or powerful individual can change – a force much like demographics; long term cyclical progressions without recurrence at the same state due to dynamic parameters of economic existence. The more appropriate response is to accept this fact, and develop skills and cash flows accordingly. While many in the “9-to-5” grouping tend to never think of themselves as “entrepreneurs” or “business people”, these are ultimately just labels for difference cogs of the same general machine/system. They are simply the group that has traded time for money in a linear fashion. This is often a great idea- nonlinear functions tend to have regions where the response functions grows (or decays) much more slowly or with more uncertainty than a linear function. While the goal in entrepreneurship is to reach the point where input time is almost decoupled from profit output, it often works against you where a massive input of time can lead to very small, uncertain profit output.  I consider “risk” to be simply the transformation of money as a nonlinear mapping of the time=money function.

Yet the two are not mutually exclusive. A steady income is important, and should be sought after for educational purposes, discipline and capital. However, do not fall into the trap. The wanna-be entrepreneur who dreams of starting their own business simply to “be their own boss” will probably lock his or herself into a comfortable, low-risk track. However, the true entrepreneur-at-heart will simply see his or her “9-to-5” or at least steady employment as a moat of safety, a further education, and a means of building capital. They will parlay all these resources into other ventures, assets and cash flows. This is in a sense the ultimate form of diversification – a portion of your “time” portfolio is dedicated to a linear occupation (hopefully one that is selected to grow the individual) while another is dedicated to the nonlinear pursuits.

So how does one do this? I am not an expert – I am merely in the thick of the journey. First, build you core competency and skill-set. Try to not tie your degree toward a direct career path, but toward a specific skill that will serve you in an uncertain world – one with economic value that you can turn to when needed to scrounge up meals and stay liquid. Build a tree of skills around this core competency and integrate. This will make you more adaptable in finding a job that will suit both you and the employer. For example, I gained a B.S. in Economics and a minor in applied math, but have focused heavily on the mathematical skills to parlay my education rather than let it go to waste. I made the mistake of student loans for an out-of-state school, so I need my education to at least pay me knowledge dividends. If the ability atrophies, it was all for naught. Keep my mistake in mind and go forward accordingly. I am doing independent research in a variety of fields and spend time learning R, Python and Excel for data analysis and SQL for database management. This tree of skills fits well into both personal pursuits and the skill requirements of employers with a core of mathematical understanding.

Further dividends can be extracted if one is resourceful and hard-working, with a heavy dose of creativity. I tutor part time, which allows for a very flexible schedule, gives me a skill I can turn to in order that I may pay bills and build capital , is fulfilling, and keeps my mind sharp. I also build a de-facto network that, if I add significant value, is more than willing to listen to me about other things (for example, I have had referrals for other businesses from satisfied tutoring clients). This is just my personal example – be creative and choose to spend your time building your “skill shell” around your “core competency”. In my next post I will list some possible examples for a few different possible “person-states” I can think of that are congruent to my model. The only requirement is to be hard working and strong willed, not lazy or easily discouraged.

 

Happy Holidays

-the UE