Volatility: Predictions and Prescriptions

As world financial markets are increasingly interconnected, events across the globe can have a significant impact here at home. The earthquake and nuclear meltdown in Japan is just a recent example. The sooner CEOs accept the reality of our fragile markets, the sooner they can begin to figure out how to mitigate risk.

June 9 2011 by Robert Lawrence Kuhn

Never again shall I relax. It is beyond me to imagine world events becoming sufficiently stable such that I might enjoy the comforting sense that how things currently are will be how things will always be. No. Never again.

I’ve been reflecting on why my global outlook has deteriorated, and I’ve concluded that it is not because there is something wrong with my mental state. I wish I were misaligned, but I believe that what I am seeing is reality. I’ve come to the sad realization that the world has changed, and not for the better. Volatility is my watchword. Disruptions, minor and massive, will occur.

The purpose of this article is to prepare CEOs to face reality and mitigate the increased risk that volatility and disruption brings to their companies. First, my predictions; then, my prescriptions.

My Predictions

I am not a prophet. I cannot forecast the future, but I fear that global uncertainty now haunts us. The financial crisis imprinted the disquieting truth that financial markets are fragile. While sophisticated financial instruments are supposed to spread risk and thus reduce risk, because financial world markets are so interconnected, unforeseen events in one place affect attitudes and markets in every place. There is no place to hide.

The earthquake, tsunami and nuclear meltdown in Japan triggered a massive sell-off in worldwide stock markets. Political uncertainty in the Arab world spiked oil prices and spooked markets. A hint of inflation or slowdown in China makes the world shudder.

Moreover, local conflicts seem more numerous and more murderous. Everywhere one looks, problems of people abound. Outsiders often cannot distinguish between the groups of mortal enemies seeking to overpower each other. Even worse is the capacity for isolated individuals to inflict widespread damage; and it doesn’t matter whether such fringe people are fanatic or deranged when they are malevolent and deadly.

It’s not that such things haven’t happened in the past, even with similar frequencies. It’s that now with our world so tightly wired together, such events trigger vicious cycles of crises engendering anxiety, which in turn engender deeper crises. We all seem plugged into the same grid of instant global information, inextricably linked by the Internet and television news, and it is this radical transformation of human existence that amplifies every issue or event, exacerbating problems while reporting them.

Futurist and inventor Ray Kurzweil claims that the exponential growth of technology will bring humanity to a state of such unimaginable productivity and prosperity that traditional human problems will become archaic. I hope Ray is right, but I am afraid that his “singularity” of vast non-biological intelligences serving human advancement may come too late: the “vestigial” human drives of self-aggrandizement, religious absolutism, and desire to dominate may wreck havoc before advancing technology can shift the outcome dynamics.

Furthermore, the more civilization is dependent on technology, the more civilization is vulnerable to its interruption. Almost everything today that makes life uniquely modern at the same time makes it uniquely fragile.

It has always been the case that single individuals could inflict harm and hold civilization hostage, but never before has its impact been so universal and so instantaneous. I am forced to expect that worse is to come. The reason that the future will not be like the past is because disruptive events have increasing power. Volatility, like death and taxes, will always be with us.

My Prescriptions

I am not a magician. I cannot stop volatility nor make disruptions disappear. I cannot prevent the illness from occurring, but perhaps I can prescribe treatments for making its symptoms less severe. Below are ways that CEOs can protect their companies from the worst of the volatilities to come.

Expect Disruptions: This is a powerful antidote; though it may seem obvious, don’t dismiss its ameliorating force. If you expect disruptions, your expectation will attenuate the emotional impact that they will have on you. It’s like desensitization training for phobias: a fear of spiders is attenuated by gradual, systematic exposure to spiders. Disruptions can come from anywhere: a local competitor with a better product or a natural disaster across the ocean. Expect them all.

Feel the Malaise: To be effective, CEOs must train themselves to expect disruptions—and such training is work. Likely, it will make you uneasy, weary, perhaps touched by melancholy or mildly depressed. For certain, if you do what I prescribe and expect disruptions, it will not feel good. It is not supposed to feel good. But get used to the feeling, and savor it. It will protect you in your hour of need.

It has always been the case that single individuals could inflict harm and hold civilization hostage, but never before has its impact been so universal and so instantaneous.

Simulate Scenarios: Once you learn to expect disruptions, you can “game plan” how to deal with them. Imagine diverse kinds of disruptions and scope out a sequence of responses to each kind. It is almost certain that actual disruptions will not be the same as those that you forecast and simulate, but the general categories will be the same and the ways of handling them similar. The exercise provides experience and builds confidence. Think of pilots in a simulator rehearsing all manner of flight emergencies and accidents.

Enable Rapid Downsizing: One way to deal with exogenous disasters is to be able to downsize rapidly. Company capacity to operate with smaller fixed costs is essential. Just as most companies now have contingency plans for nonstop continuation of computing services during crises, companies should have contingency plans for shrinking overheads to meet sudden emergencies. Mechanisms may differ but thinking carefully about how to downsize will inoculate against disaster.

Diversify Geographies: Most disruptions, such as natural disasters and political turmoil, happen in specific locations. Some places may be intrinsically safer than others but no place is immune, and it is often those regions more susceptible to instability that have certain material advantages such as low-cost labor. The simple answer is to reduce your company’s concentrated country exposure by enlarging your geographic footprint, but this reduces efficiencies of scale and complicates scope of control. These are natural tensions, but if one believes, as I do, that disruptions will become more potent as well as more likely in the future, then CEOs might consider greater geographic diversification even when sacrificing other business benefits.

Diversify Products and Services: Dependence on one (or on a small number of key product areas) carries increased risk. This does not mean that companies should expand outside their areas of core competencies (which could be like treating your tennis elbow by amputating your arm). Companies should assess their prime products and services to determine which might be countercyclical, that is, which would be more useful to customers in times of crisis.

Deleverage Balance Sheets: Leveraged companies generate better returns in good markets but become far riskier in down markets. If one expects disruptions, it is wise to sacrifice return on equity in the short term in order to achieve safer debt/equity ratios over the long term. It is better to be criticized for suboptimal returns than for a bankruptcy.

Count on this: For the rest of our lives, our world will be subject to waves of volatility, perpetual and unpredictable. So prepare for disruptions. And never relax.