The future is inherently unpredictable and experts are frequently wrong. Experts often profess in articles and reports that a certain outcome will occur, yet in some cases, the exact opposite occurs. When managing a business, it is customary to put considerable faith in what experts expect to happen. To mitigate uncertainty in business decisions a prudent manager will attempt to manage in such a manner that if the worst happens, the business endeavor or investment will be recoverable.
Two rules that a prudent manager should always follow are:
- When doubt exists, commit funds in a manner that leaves room to maneuver if the outlook changes.
- Test your ideas before committing large funds to any project.
I have two examples that illustrate these points:
In early 1981, I was approached by an individual in his mid-60’s who had just sold some property and had approximately $500,000 to invest. He did not want to invest in stocks and instead wanted security for both his principal and an income. At the time, Henry Kaufman – chief economist of Salomon Brothers – had established himself as the interest rate guru for US media. Interest rates had been rising relentlessly and Kaufman had been constantly publishing articles saying that interest rates would increase. At the time of our meeting, interest rates were at about 20 percent with Mr. Kaufman forecasting an uptick to 30.
The client and I had a general discussion and decided that buying bonds that had a maturity date of 15 years or more would achieve both of his objectives. If interest rates went up, he could hold the bond to maturity and get his investment back while also collecting substantial interest. We concluded that interest rates would exceed the suggested 30 percent, and perhaps go higher. This was a major concern as it could potentially cause the bond prices to decline. To mitigate this risk, we decided to commit half of his funds to long maturity bonds now and then invest the rest in $50,000 amounts over the next year or even sooner if it appeared that interest rates would decline. His thought was that 20 percent interest would give him all the income he would need and also offer the potential for capital gains when the bonds were sold.
I did not see this gentleman until he showed up at my door 20 years later. In the discussion. In the discussion that followed, he said that he had invested half of his money in bonds immediately and the rest over the next six months. Interest rates had started to decline and waiting did not seem prudent. He was very pleased to announce that he had made a huge amount of money with the bonds as interest rates declined. His only lament was that he was not able to reinvest his funds at a similar interest rate. By not committing all his funds at the onset, he had the ability to invest his money at an even higher rate if the interest rates climbed as forecasted.
If you have an idea for a business venture, you should try and test your idea before committing significant funds to the project. Sometime around 1985, I was asked to assist an entrepreneur who was certain he had a great idea to make money. His plan was to reduce the space video stores needed to display their movies. At that time, the video stores would take the video out of the box and put the box on a shelf. These boxes were large and took up a lot of space. The entrepreneur thought that small four by six-inch cards in a plastic sleeve would save each video store considerable space so more movies could be displayed.
When we first met, he had progressed to the point where he was ready to do his initial mailing to video stores in North America. To do this, he had obtained approvals from numerous movie studios to print the cards for the movies that they had on video tape. This was expensive, but it was necessary due to copyrights. On top of that, he had to purchase artwork, plastic sleeves, and do an initial mailing complete with samples. As the costs added up, I asked him if he had approached any of the local video stores about his idea. His response was that he was afraid to talk about his idea as someone might steal it. At this stage, I could not be of any assistance but suggested that I would contact him in two weeks.
When I followed-up and asked how the mailing went, he said that he had not received a single order. I was astonished as I had been captured by his idea and enthusiasm. When I asked what happened he said that the video store shelves were constructed in such a way to accommodate the boxes. His idea would be suitable for a new store, but to change an established store would have been too costly. The moral of this story is that it is paramount to test and retest your ideas before committing funds. If the gentleman in this example had simply spoken with a few stores, he would likely have found out the problem long before spending substantial time and money.
Running a business is difficult and even the experts are often wrong. What can you do? Test your ideas, and make sure to always leave financial room to maneuver when something does not turn out as you expected.
By John Alton
Financial Management
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