Prediction to Creation: the necessary strategic shift

| Uncategorized

Headlines spruik it, politicians proclaim it, the masses consume it: we live in a volatile world!

The Covid-19 pandemic has seen unprecedented global reactions, with drastic interventions announced almost daily by governments and corporations alike. Global stock markets have tumbled 30% since the beginning of the year[1], US crude oil prices fell 24% on Wednesday to the lowest they’ve been since just after 9/11, and panic buying is stripping supermarket shelves bare. Entire countries are in lockdown as airlines announce the complete cancellation of all international flights. Volatility abounds, and it is reflected in the Chicago Board of Exchange’s Volatility Index, the VIX, which ended a record high on Monday, surpassing the levels seen at the height of the Global Financial Crisis.

CBOE VIX chart

With the world obsessed with the word volatility, it is prudent to understand what it actually means. At its core, volatility is a deviation away from what is expected. It has a mathematical formula and, in financial circles, seeks to inform estimates of the potential risk of a certain investment. It sits at the base of many predictive tools that underpin trading strategies and valuation techniques, which become increasingly irrelevant as uncertainty increases. Let’s use the case of Long-Term Capital Management (LTCM) to illustrate this point.

LTCM was founded by former Salomon Brothers Vice Chairman John Meriwether in 1993, along with Nobel Memorial Prize winners Myron Scholes and Robert Merton, perhaps most famous for co-creating with Fischer Black the Black-Scholes-Merton option pricing model. Together they went about raising a hedge fund from high net worth individuals, corporations, and university endowment funds. When LTCM began trading in February 1994 it had over US$1billion in capital under management, at the time the most money ever collected to start a hedge fund. It would peak at almost $130billion in just five years before its ultimate demise.

The fund employed a leading-edge technical trading strategy known as convergence trading, placing paired and opposing bets on similar assets for financial gain. The trades relied on volatility-informed quantitative models identifying variances in predicted fair values over time, and performed astonishingly well in the relatively stable mid-1990s: annualised returns were in excess of 40%. LTCM was the darling of Wall Street.

The Russian Financial Crisis of August 1998 was an unexpected event that was not captured in LTCM’s predictive models: nobody at that time expected a sovereign nation to default on its government debt. It precipitated a series of equally unexpected actions which saw LTCM’s value drop to just US$400million in late September, with debts of over US$100billion. The collapse was considered too large for the global economy to absorb (LTCM held positions amounting to roughly 5% of the global fixed income market) and a bailout was organised by the Federal Reserve in order to avert a slip into default.

Long-Term Capital Management performance over time

How could it be, you may ask, that the smartest minds in the business employing leading-edge investment methodologies with returns over several years suggesting significant out-performance could fall from grace so suddenly? The answer lies in the difference between volatility and uncertainty: between prediction and creation.

When factors are known, prediction wins hands down. Even when volatility is high, if we can identify the factors that contribute to a desired outcome we can model their behaviour based on past experience and predict, within acceptable tolerances, the likely outcome. This is the realm of risk assessments and strategic management and the basis of operation for the vast majority of established organisations. Out-performance relies on the relative skill supporting the predictive processes and the firm’s ability to implement effective strategy, as exhibited with the early years of LTCM.

When uncertainty exists, however, prediction becomes as useful as a flip of the coin in making decisions. The unexpected and unexplainable events that underpin an uncertain environment undermine the very assumptions which support an effective predictive model. As was the case with LTCM and the Russian Financial Crisis, events occur which are not included in volatility-informed predictive models (like typical corporate five-year Strategic Plans) which make impotent the competitive tactics employed by firms.

I am, of course, paraphrasing the early work on risk versus uncertainty authored by Frank Knight in his 1921 work Risk, Uncertainty and Profit. Considered the main founder of the “Chicago School” of economics, Knight espouses a difference between the concepts of risk and uncertainty, centred on the defining feature of whether there is quantifiable knowledge of a possible future occurrence. Risk is a measurable unknown, whilst uncertainty is distinctly different in the sense that it is immeasurable and therefore inappropriate for use in traditional strategic management practices.

Knight went on to purport that entrepreneurs were the economic agents most adept at dealing with uncertainty, and were therefore deserving of economic profit when uncertainty abounds: they were the masters of uncertainty. They have a particular way of thinking, reasoning and acting that gives them an unfair advantage when things are not known.

entrepreneurs are the masters of uncertainty

This view has only been confirmed over time, with work by the likes of Peter DruckerHoward StevensonJeffry Timmons and Saras Sarasvathy fine tuning our understanding of what constitutes the entrepreneurial method. At the core of this approach is a means-based view to sensing and seizing opportunities. Entrepreneurs have a strong focus on “what they have” to launch ventures, not on what might be. They have a good understanding of their set of resources (knowledge, network and -crucially- their passion) and make decisions based on where they hold relative strength. That is why we see so many entrepreneurs launch ventures in industries where they have experience, often first working for traditional firms before starting their own, or in areas where they desperately want to make a difference.

I want to double down on this last point in order to tease out the complexity of the entrepreneurial method. You see, it is not as simple as identifying the right process (e.g. customer discovery and the lean startup approach): there are personality characteristics and sources of motivation to consider amongst others. Entrepreneurs are significantly motivated by a need for power. This may sound confrontational, but when you investigate the construct of what a need for power is, you will find entrepreneurs around the world nodding their heads in agreement.

entrepreneurs have a need for power

At the core of a need for power is a desire to influence: to influence people, to influence organisations, to influence industries, to influence entire economies! You might consider Elon Musk and his desire to change the automotive industry or Anita Roddick with her intense desire to impact people around the world to see this motivator at work. I challenge you to engage a local entrepreneur and ask them why they started their business: you may be surprised at what sits underneath the intense desire to succeed. In the case of my wife’s business Pet Wellness Centres it is to help pets live longer, healthier, happier lives. This emerged from a frustration with the existing level of care in the industry, a particularly poor experience with our own dog Brain, and a personal desire to raise the bar for all. That, and the fact she had previously built a dental group from startup to over 75 clinics employing more than 1,000 staff (dental is quite similar to veterinary services).

Elon Musk as a catalyst of change in the automotive industry

I mentioned the entrepreneurial method is complex, and I have introduced but two attributes above. Another is the fact that entrepreneurs typically undertake an entrepreneurial venture by first assessing and accepting the likely downside – check out Tim Ferris’ approach called fear setting. Also at play are personality characteristics like social orientation and propensity for risk taking, and specific areas of entrepreneurial knowledge. I could spend several days unpacking the intricacies of our complex understanding of the entrepreneur and the entrepreneurial organisation.

The beginning of 2020 has brought to a head the fact that we live in an uncertain world, not just a volatile one. This uncertain world demands a different approach to commerce. We cannot continue to rely on tools, techniques and tactics born in the second and third industrial revolutions: to do so is folly and will precipitate our downfall. Almost one hundred years after Frank Knight’s seminal insight, 2020 has become the year of the entrepreneur and the entrepreneurial organisation. In a world of uncertainty those with entrepreneurial capability hold the secret to success: they are the masters of uncertainty and will thrive while traditional organisations face declining performance and slide into obsolescence. To succeed in an uncertain world we would do well to take the advice of both Peter Drucker and Abraham Lincoln:

“the best way to predict the future is to create it”

[1] DJI 31% | FTSE 33% | Nikkei225 29% | ASX200 26% | DAX 37% | 02 Jan – 18 Mar 2020

End Note: I give thanks to David Todd, Head of Entrepreneurship at The Scots College Sydney, for inspiring this train of thought and motivating me to put it into words.

Comments are closed.