margin of safety – The Waiter's Pad

One framework for investing is the bathtub model. Individuals (but also managers of OPM like pension funds, endowments, etc.) aim to fill the tub as much as possible. An individual’s main stream is their salary. Maybe some salary first goes to an investment, and then pours in the tub. A rental property, a second job, a military retirement are inputs too.

But the tub doesn’t just fill up, it drains too. Losses in the market are like leaks in the tub, hopefully we can mop these up and dump them back in. The big four unexpected costs: health, house, job, spouse are major leaks. Retirement is the intentional draining of the reserves.

More water and more pressure is good. Fewer and less severe leaks are good. One way to add on net are uncorrelated assets. What flows faster as something leaks more? Real estate and gold are classic examples. Bitcoin too – kidding! ‘All weather’ and ‘cockroach’ are portfolios which blend assets for uncorrelated returns. The goal is to prevent major mop ups or total losses.

But the best and only uncorrelated asset is mindset.

A common mindset during drawdowns for investors who dollar cost average is that stocks are on sale. This attitude goes beyond investing. When something bad happens it’s a chance to get stronger. Another is, you’ll have a great trip or some really good stories.

The world is complex. There’s a lot going on, sure. But also ‘a butterfly flaps its wings in Kansas and causes a Tsunami in Guam’ complex. How does someone plan for just what’s happened since 2016?! How do investors (but also managers of OPM like pension funds, endowments, etc.) find that someone? Not only is our mindset the best and only uncorrelated assets, it’s ours to control. We can want less or more. We can view the obstacle as the way. We can match expectations to reality.

One of the things brought to light by Covid has been the balance between capacity and efficiency. In general, things with high excess capacity aren’t efficient and things with high efficiency lack excess capacity. Another way to think about capacity is as a margin of safety.

Each link in the medical supply chain, wrote Scott Gottlieb, balances capacity and efficiency. Swabs, like those for Covid, are produced efficiently.

“One of the things I learned at the FDA, watching other critical medical products go into shortage, is that it’s often the lowest-margin constituent in a complex supply chain that’s most vulnerable to shortages. Often the only way to produce such a part profitably is to manufacture it at a very large scale, which means it’s likely to be made by a small number of big, consolidated suppliers.” – Scott Gottlieb, Uncontrolled Spread, published 2021

Sixty percent of the swab market was from an Italian supplied, an Italian supplier in the Lombardy region. Eventually the United States scaled up swab productions only to be limited by the machines that ran the tests, another part of the system where the incentives pointed more towards efficiency than capacity. A system is only as strong as the weakest-link-in-the-supply chain.

There is a tradeoff between efficiency and capacity and that tradeoff depends on time and consequences.

“Flatten the curve” demonstrates this. Our highly efficient (low capacity) healthcare system could have been overrun. The consequences of that were huge. One physician friend thought she might have to work in a field hospital – and she’s a dermatologist.

A smaller example is a student taking Algebra. If an Algebra exam is during a sport season, the student will have less time to study being highly efficient with their use of time. The lack of capacity might lead to a lower grade.

However, in the case of Algebra, the time and consequences are more muddled. Is the goal to ‘learn Algebra’ or ‘score 93% on the Algebra Chapter Two Test’? In the case of the former, the time pressure changes.

Personal finance encompasses this idea too. A large capacity is an emergency fund. Those dollars could be invested to earn the historic seven percent. Time here matters too. Typically a person has one source of income (their job) and these vary in pace of payment. A salesperson can work more – and get paid more faster – than a bookkeeper. Their time aspect is different and the consequences for each depends on the difference between income and expenses.

Like the tuning of stereo, these three aspects can be balanced to fit the conditions. There is a trade off between efficiency and capacity. There are consequences in that exchange. And there is cadence for reaction.

Big shocks, like Covid, are out of our control. But though exogenous to our life, there’s still at least three dials to get things that sound right.

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Tag: margin of safety

The best uncorrelated asset

The capacity-efficiency tradeoff components