Fragility and Robustness

The financial crisis of 2008 has brought the impacts of debt and uncertainty into focus for many people (who are not not part of the government). The key to understanding bubbles and the recent financial crisis are the concepts of fragility and robustness. For the purpose of our analysis is to analyze the difference between these two concepts and examine how they apply to our personal, professional, and financial life.

Simply defined, fragility means that something is weak and prone to breaking. This is the term that many use to describe the impact of debt leverage on the financial markets and overall economy. The general impact of debt or leverage is that it amplifies both returns and losses. If you borrow $100,000 at 5% interest and invest it to earn 10%, you have just earned $5,000 with zero invested capital. Your return on investment is infinity. On the other hand, if you lose 10%, you will have lost $10,000 plus the $5,000 of interest expense. This adds up to a total of $15,000 in losses that you may not have enough money to pay. This is the reason why debt contributes to fragility. It amplifies gains, but places you subject to crippling losses. An example of fragility in our personal life is using debt to live beyond your means or financing a home that you cannot afford. Even the slightest hiccup in your economic situation will create a downward-spiral that eventually destroys your credit and your finances.

On the other end of the spectrum is robustness. In simple terms, being robust means that you can adapt to changing situations without undue difficulty. The far extreme of robustness is to purchase everything with cash. A more measure example would be to modulate your spending by your income or to ‘live withing your means’ at all times. A famous way of communicating this concept is to ‘spend less than you earn’ and not to ‘earn more than you spend’. The importance of this distinction is that modulating spending by your earnings requires that you produce first before consuming. On the other hand, spending before you produce means that you will always be seeking the next ‘big deal’ that will help to pay for money that has already been spent. This is a prime way that people become subject to scams and shady deals.

The importance of these concepts is not to say we should pursue one or the other, but that they represent a continuum. Many people can realize tremendous benefits by analyzing where they stand on this scale, and determine to pursue an optimal balance. Some people and organizations (such as the government) use debt as a method for living beyond their ability to produce without any clear notion of how those future debts will be retired. (In the case of the government, debt retirement is most likely to happen through inflation) This extreme fragility subjects you to tremendous volatility if anything happens outside of our expectations. On the other hand, the pursuit of extreme robustness can leave considerable opportunity for gain on the table. The least volatile investments are typically the ones that produce the lowest rates of return. Debt that is used to purchase an income producing asset can be very beneficial if the asset produces positive net cash flow. In this way, you can ‘outsource’ the payment of your debt to the asset that has been financed.

Ultimately, it is important to understand that the future is necessarily uncertain. Nobody knows for sure when the next boom or bust will occur. Creating a lifetime of wealth and happiness requires that we find the optimal balance of fragility and robustness in our personal, professional, and financial lives. Overall, things that are efficient for wealth creation tend to be fragile and things that are inefficient for wealth creating tend to be robust.

This concept is equally true for business as well. Businesses with high variable costs, or high capital costs tend to be fragile since they require either stable prices or large volumes to be profitable. This types of business is easier to start and grow, but is very fragile against economic disruptions. Conversely, you may have a scalable business (Frequently in the information marketing or publishing segments) where both fixed and variable costs are low. In this model, it is extremely difficult to gain traction in the marketplace because of intense competition, but there are tremendous gains that can be achieved and the business is insulated against cost increases or volume disruptions creating a downward spiral.

In the end, each of us need to find our own balance of fragility and robustness. The importance of this analysis is less about arriving at one particular answer and more about going through a thorough and honest self-analysis. For people whose life is overly fragile, changes must be made to bring about more robustness. For people who have been overly conservative for the sake of robustness, it may be rational to take more measured risks for the sake of capturing opportunity. As with all things, the choice is up to you.

Sincere Thanks,
Douglas J Utberg, MBA

Founder – Business of Life LLC:
http://www.BusinessOfLifeLLC.com/

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Category: Personal Finance Tips