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An Approach to Risk Management
ARCHIVED - COMGEST INVESTMENT TEAM - 01.07.2013
The furu, the local name for a small, bony cichlid fish found in Africa’s Lake Victoria, had no natural predators for centuries. It evolved into hundreds of subspecies, each adapting and becoming biologically optimized to specific niches in the world’s second largest freshwater lake. This idyllic existence came to an abrupt end when the Nile perch, a large predator fish, was introduced to Lake Victoria in the 1950s to give fisherman a catch better suited to commercial fishing. The Nile perch decimated the furu population, as since there had been no need for natural defenses before the perch came along, the furu had never developed any.
The story of biological species highly tuned to a specific environment and unable to deal with change is repeated countless times through history, from the dinosaurs hit by abrupt climate change through the dodos felled by the arrival of people. But the cockroach was around with the dinosaurs, watched the dodo go extinct and furu population crater, and is said to be a good bet to survive a nuclear war. Why are cockroaches so much more resilient than so many other species? How have they been able to survive while other species rise and fall?
The answer lies, at least in part, in the cockroach’s defense mechanisms. It simply reacts to changes in air pressure, meaning it runs away whenever it feels a slight breeze. (If you’ve ever tried to squash a cockroach, you’ve seen this in action.) In biological terms, this is a “coarse” organism, one that is better able to survive in many environments, but won’t do as well in any given environment. The furu, dinosaurs, and dodo, on the other hand, are and were much more complex, and much more “highly tuned” and optimized to their environment. They all did extremely well while conditions stayed the same. But once the environment changed in a way they hadn’t predicted – and in a way for which they weren’t prepared – they couldn’t cope and disappeared1.
Biology Has More In Common With Economics and Investing than You Might Think
Business models and investing strategies can be classified the same way: those that are coarse and able to withstand shocks, and those that are highly tuned to do very well in a specific set of circumstances, but poorly in others. The financial crisis of 2007-2009 provided plenty of examples of companies with business models that were either coarse or highly tuned. For instance, AIG signed massive amounts of debt-insuring derivative contracts that didn’t require the insurance giant to post collateral as long as its credit rating remained above a certain level. Once AIG was downgraded, though, there was no way it could come up with the cash to post as collateral. As long as conditions continued such that no collateral needed to be posted, AIG was fine, and even doing well, posting record earnings. But the minute that changed, AIG was pushed into extinction (or would have been if the US government hadn’t come up with a multibillion dollar capital infusion).
This paper was originally written in 2013 and has not been updated since publication.