Nassim Nicholas Taleb popularized the understanding, or at least awareness, of fat-tail risk. A typical distribution curve has narrow tails at each end showing extremely low, nearly nonexistent, probabilities of one of these rare events occurring. Taleb teaches us that “rare events” happen with much greater frequency than we assume and foresee. The tails are “fatter”.
He then takes it a step further and illustrates the insanity of making low-reward bets, which under normal circumstances will nearly always pay off, but occasionally will lead to blowing up.
If I have a 99% chance of making $1, but the 1% of the time it does not work out I lose $100, I should not make the bet. I have a negative expected return. Seems simple. However, the human brain assigns much more value to the consistency of the 99%. We are easily fooled.
Just because something generally works, does not mean it always works. Planning for that eventual failure and ensuring you can survive it, is critical.
I write a lot about cash and leverage. Why? Because too little cash and too much leverage is the easiest way to destroy an otherwise functioning business. All it takes is a slightly fatter tale than we assumed, a rare event, and boom, our business is gone.
Why operate that way, with too little cash or too much leverage?
Simple, recently it has worked. It has been the 99% play. We are coming out of a 15-year period where interest rates were at historic lows and credit was easy. It did not pay to hold cash and it cost very little to borrow it. It became all the rage to hold cash levels at bare minimums to be “more efficient” and present more attractive KPIs. But as Taleb would say, being more efficient and having an attractive KPI are low-reward bets, and the flip side may mean blowing up.
Now the story has changed. We can sit on a large cash position and invest it in risk-free T-bills earning more than 5%. Any renewal of credit is going to now be more costly and so it pays to do the opposite of what has worked the last decade plus.
Maintain low, manageable debt levels and build up a surplus of cash. When the eventual rare event hits, you will be prepared and survive.