In our latest quarterly letter, Paladin Advisors suggests a way to thrive in a world of unpredictable and disruptive change. In the spirit of the Stoics, we explain why an anti-fragile mindset can be helpful in dealing with the challenges of difficult markets, difficult people and/or undesirable trends. This is one of our more abstract pieces but, I believe, one of our most important.
Anyone reading Paladin’s investment commentary knows that we identify many recent developments in markets, the economy, and society at large, as unsustainable. But what does that really mean? It means, in the immortal words of Herb Stein, that what cannot go on forever must end. That’s because some trends, unabated, lead to untenable extremes: markets become overpriced, ecosystems collapse, and/or social conditions become so bad that no one—not even those who benefit from them—accepts them as fair. That said, history is replete with examples of ‘unsustainable’ trends that persisted much longer than anyone could have imagined. Identifying turning points (in markets, society, or in everyday life) is always difficult, except in hindsight.
Therefore, rather than thinking in terms of prediction, one should instead think of planning. Our decisions reflect tentative plans for engaging with the world as we see it unfolding over time. It can be useful to imagine, and to ask ourselves, "What could go wrong?" In managing our clients' portfolios, and our business, we make sure that no one is badly hurt if markets don’t stick to the script. We consider that a minimum criterion for success. Our larger goal is to become stronger in response to changes in the script. That sounds nice, but how?
Nassim Taleb’s masterful book: Antifragile, has quite a lot to say about this. Human societies (and businesses) seek efficiency through automation and specialization. Better tools and processes improve productivity, but often at the cost of making our systems more fragile. We see it everywhere. Monoculture farming boosts crop yields and feeds more mouths, but makes our food chain vulnerable to disease, disruption and the arrival of new pests. Aggressive firefighting minimizes damage over many years, while creating the conditions for conflagration, as tinder and (and new homes) accumulate. Automation of everything from maps to manufacturing to airplane software has improved efficiency and safety, while making us ever more dependent on, and less able to manage, our tools. Integration into the global information network vastly expands our analytical capabilities, while making us more vulnerable to ransomware, data theft, internet trolls and simple procrastination. It’s an age-old cycle of change: efficiency brings complexity, which creates new risks and setbacks, which are managed with new and more complex processes.
The process of progress, or what we call “managed fragility,” has gone into overdrive with recent technological advances. Computers and artificial intelligence are dramatically improving the efficiency of various industries, while creating a new host of risks. Many have written about the social costs of automation and loss of privacy, but less attention is paid to the consequences of sweeping behavioral “management." The objective of most large tech firms is (in Shoshanna Zuboff’s words) to create and dominate markets for behavioral prediction. Over time this prediction is veering into manipulation. What happens to social diversity when the managers of these tools seek to control not only peoples' actions, but also their thoughts? What happens to biological diversity when genetic engineering becomes more common? Is human society becoming ever more fragile, even as we become more adept at controlling the world around us?
Markets are made of people, and reflect the same patterns of accelerating efficiency and specialization, accompanied by increased fragility. Right now, we believe they are very fragile indeed. Central banks have made investing ‘safer’ over the last decade, encouraging ever more risk taking. Governments have been borrowing without any sense of natural or financial limits. Corporations have been buying back shares like mad, leveraging up their balance sheets. And don’t even get us started on market valuations! The conditions for a setback in markets are firmly in place. One wants to be more anti-fragile than usual in circumstances like these.
How does one deploy an anti-fragile mindset in investing? You start by tilting your portfolio toward assets likely to perform relatively well amid dislocation in highly-valued markets. Value investing, and avoiding the lowest-quality assets are a big part of this. Accumulating cash when asset prices are too high is another strategy. Both approaches forego opportunities created in a high-momentum bull market, but allow us to avoid the worst potential drawdowns. More importantly, they allow one take more risk when prices (and opportunities) are better, setting the stage for a strong recovery in markets and portfolios.
From the business perspective, being anti-fragile is a little different. We prioritize resilience over efficiency, based on the concepts outlined by Martin Reeves, which he described as ‘biological thinking’. We focus on building redundancy, diversity across product lines, suppliers and customers, and modularity in our operations. Above all, we try to be prudent in our planning and management. Our decision making is evolutionary rather than revolutionary. We would love for this company to be around for 100 years, willing and able to serve the descendants of our current clients.
A corollary to our focus on resilience is that we do not seek to maximize return to our “shareholders.” We eschew shareholder value added (SVA) as a concept and instead practice Customer Value Added (CVA), consistent with our fiduciary duty. Jack Welch called SVA the dumbest concept in the world, and we agree. Chasing assets (which creates a conflict of interest between current and future clients), escalating fees (which hurts portfolio performance) and/or curtailing service (which makes everyone’s life more difficult) have never been goals of this firm. Since we’ve been successful without doing any of those things—and clients seem to like the way we operate—we think a holistic, mutually-affirming approach is both viable and honorable.