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.