How NOT to miss an important lesson from COVID-19!

Today's leadership blogpost is dedicated to Peter Drucker. Drucker was an educator and author, whose writings are considered by many to be at the foundations of modern management theory. In this post, I'll present an important lesson from the COVID-19 pandemic and discuss how to apply the learnings not just in that specific problem area (supply chain) but also in your own life: Personal Finance.

But first, I will start with a pertinent excerpt from Drucker's book, 'Management Tasks, Responsibilities, Practices':

"The whole of a system is not necessarily improved if one particular function or part is improved or made more efficient. In fact, the system may well be damaged thereby, or even destroyed. In some cases the best way to strengthen the system may be to weaken a part—to make it less precise or less efficient. For what matters in any system is the performance of the whole; this is the result of growth and of dynamic balance, adjustment, and integration rather than of mere technical efficiency. Primary emphasis on the efficiency of parts in management science is therefore bound to do damage. It is bound to optimize precision of the tool at the expense of the health and performance of the whole."

Efficiency came at the cost of Resilience

Let's rewind the clock back to the pandemic days... Supply chain shocks, Auto manufacturers having to shutdown plants and stop production because of chips shortage, empty store shelves, etc. Why did all of this happen?

Of course, there isn't a "root" cause in complex systems. But, from the perspective how what mistake to avoid in the future, I'd argue that our blind chasing of efficiency is at the core of this matter. In this case, many business leaders for the past couple of decades were blindly chasing efficiency - Just in Time inventory, squeeze as much juice out of the supply chain as possible, etc. - Why pay the high storage cost of buffer inventory, right? This in turn boosted quarterly profit margin which then boosted the share price.

This is akin to a person trying to lose weight being happy to see the numbers go down on the weighing scale after surgically removing part of their liver. Because of this blind pursuit of efficiency, manufacturers had no room for error and no margin of safety! All of this imploded in 2021, right in front of our eyes.

I'm sure some of the companies that got impacted are now carrying buffer inventory of key parts and building resiliency in their supply chain and production capabilities. But, I'm not sure if they have looked to see if the same type of mistake is being made elsewhere in the business.

We usually learn lessons only from the particular - but not from the general. We try to solve superficially for a particular "problem" that we narrowly define, but don't understand the fundamental underlying insight behind the solution that then can be generalized so that we can apply it to various other areas. As Dr. Edwards Deming put it,

“Experience by itself teaches nothing... Without theory, experience has no meaning. Without theory, one has no questions to ask. Hence, without theory, there is no learning.”

In this case, efficiency came at the cost of resilience and we are still paying the price of the knock-on effects. I invite the reader to explore the pitfalls of chasing optimization in complex systems on their own, but I'll move on to talk about how to apply this insight to your personal finance.

Personal Finance

I'm not a financial advisor. This is not financial advice - also, context-free advice can be dangerous. Rather, it is just my own thoughts/opinions and lessons learned as a ~45 year old person that has lived in a couple of different countries and observed people of various age groups and cultures managing their finances. Note that many aspects of the discussion is USA-centric (I live in the Bay Area) but hopefully the examples are generic enough to resonate. Over the years, I've seen quite a few of my colleagues, friends and family go through tremendous personal pain due to their finances (including money lost or owed to others).

Obviously, a full-blown bankruptcy is what comes to mind immediately, but sometimes it could also be that they feel trapped unable make the decisions they want to make, as life changes around them. When you dig deep, it becomes obvious that they are unable to follow their heart because they may have a huge financial commitment/burden for the next several years that limits their options. I don't know what's worse, the pain of bankruptcy or this type of long-term chronic pain.

I usually try to figure out what psychological state they might've been in, when they made their financial decisions - both in calm and rough waters... I'll explain one such pattern as an example. Again, I'm not talking about gamblers or people who lost money in crypto currency scams or NFTs - just smart people who had good jobs, lived below their means and saved the rest.

During calm waters, they made good money and are left with "extra" cash that then starts to accumulate. Note that last several pre-pandemic years were the era of low interest rates and high stock market growth. Many financial advisers recommend to keep aside only six months worth of expenses as cash - as a buffer amount to hold for emergencies.

People became very restless to see ANY cash on top of that "emergency" cash sit "idle". A high yield savings account or a CD wasn't enough. They wanted to squeeze more return on their cash and so they either bought into stocks or bought a home with a mortgage. It was a very efficient portfolio allocation - but, was it effective during rough waters? Let's find out...

Imagine they invested rest of their "non-emergency" money in stocks (say in low-cost index funds like S&P 500 - as advised by some good friends). This investment can potentially drop 30%, 40% or even 50% in a short duration. Most panic at this stage and sell at a loss. Let's not forget that a 50% drop takes a 100% rise to break even. Accordingly, our pain of losing $10,000 is twice as much as gaining $10,000.

Let's not forget what happened in 2020. From the Feb. 19, 2020, high to the March 23 bottom, the S&P 500 declined about 34%. Many panicked and sold. Many were also forced to sell when they lost their jobs during the pandemic.

Even if you are the one that can stay calm during a stock market turmoil, you might learn lessons from Murphy's Law. One fine day, your roof might collapse in the rains and take your six months buffer cash with it. As Amos Tversky put it,

“He who sees the past as surprise-free is bound to have a future full of surprises.”

Also, as the saying goes, the market can remain insane longer than you can remain solvent. If you are forced to sell your stock or low-cost index funds after a massive drop of 50%, you'll lose even more wealth in the long-term. Let's also not forget how many people had to give up their homes or get evicted during the global financial crisis of 2008.

Of course, if you are young and have the skills this world needs, you can afford to take more risks. But, it is hard to imagine ourselves in a spot when our investment portfolio collapses by 50% and try to guess how we'd react if we had no spare cash left. Note that larger the raw $$$ amount, the more the pain even if the percentage loss is the same - losing $5000 out of $10000 is not the same as losing $1 Million out of $2 Million.

Here is what I did: I kept enough cash and didn't seek efficient allocation of my cash during the low-interest regime. But, that made me sleep better at night during March 2020 - I didn't panic and actually bought my index funds as usual, in an automated fashion.

How much cash to hold is something you have to decide for yourself - we are all built differently. I found mine and you should find yours. Of course, it is much easier to hold cash (~T-bills) now in a 5% interest rate regime compared to back then. For what its worth, let's see what the legendary investor and student of Benjamin Graham, Warren Buffett does... Berkshire Hathaway holds a record ~$157 Billion in cash (as of the last quarterly report).

Why do I hold a lot of cash and thus inefficiently allocated in an inflationary environment? I don't know what good opportunities might come along in the next few months/years. I also don't know what bad things will happen to me and my family!

So, will the stock market go up or down in 2024? I don't care! As Benjamin Graham put it,

"The purpose of the margin of safety is to render the forecast unnecessary."

This is a fundamental lesson in risk management - it can't rely on your ability to accurately "predict" the future, which is not possible, expect by chance.

Wrapping Up

So back to business leaders: What can they do instead?

If not efficiency, what then? Effectiveness!

Also, here are some lessons to be learned from the bees 🐝: Part 1 and Part 2.

And some more lessons from The Bhagavad Gita.

I'm not a proponent of 'new year resolutions'. But, I wish we all took this lens of 'efficiency vs effectiveness' into various aspects of our life and work in 2024 and learn profound lessons from it. Let's not forget that lessons will be repeated until we learn.

I'll end today's post with a quote from Peter Drucker:

“There is nothing quite so useless, as doing with great efficiency, something that should not be done at all."

Happy 2024!

[In case you missed my previous post - it is dedicated to Charlie Munger and centered around taking a multidisciplinary approach to leadership.]