What May Start-Ups and Retired Households Have in Common?

fg1Retirement Income Industry Association Founding Chairman, Francois Gadenne, has contributed numerous essays to this blog (soon to be called a “magazine” because that’s what it has turned into). Today Francois explores the similarities between the financial challenges of start-up companies and households. It’s an interesting way to look at financial dynamics which show remarkably consistent characteristics.

A key to understanding the 20th Century is to focus on the development of science. In particular, towards the end of the century, cumulative growth in science brought about a widely visible convergence of once diverging fields under a common narrative – evolution/systems dynamics – that allows for the explanatory merger of nature and culture and just about everything else.

For instance, think of Physics and Chemistry, Computer Science and Biology, Geology and Genetics, etc.

I remember the despair felt while studying in France in the 60s and 70s as it appeared that we were all condemned to make a life-limiting choice to become specialists who would be increasingly unable to communicate with one another. I also continually feel the surprise and joy since the 1980s with the increasing diffusion of generalizable findings from System Dynamics, to the New Darwinian Revolution and Complexity Theory etc.

Relevant concepts include the difference between stocks and flows, feedback loops vs. simple causality, time delays vs. immediate feedback, linear thinking vs. structural non-linearities, etc.

And, for the investment industry in particular, all of this matters before we even get to our own bounded rationality, biases, distortions, errors and defensive routines that we learn about in Behavioral Finance.

Here is a small example of such convergence in our industry: What may start-ups and retired households have in common?

Let’s start with the start-ups.

How do you kill a start-up company? There are probably more than 50 ways, but one has always amazed me because it often seems to surprise so many entrepreneurs. It is indeed counter-intuitive and it fits in one word: Growth.

The device that turns growth into a start-up killer is working capital. The enabler is success as evidenced by the growth of the business and its increasing demands for cash. As you grow, it is easy to let working capital requirements grow faster than your ability to raise cash from existing operations, lenders or investors. Pretty soon, you can run out of cash entirely.

This is an example what can happen with delayed feedback.

This puts the start-up at the mercy of the next round of funding and the tender mercies of funding sources, if they are available. Venture capitalists thrives on the situation while entrepreneurs get stomach ulcers. Funding the growth will leverage great wealth away from the latter and toward the former. This reality can be made more tolerable if the start-up is a home-run (rather than a single), grows far beyond initial expectations, given the injection of capital, and beats its competitors since start-up economics often leads to a winner-takes-all outcome. But what are the odds?

How does this relate to retired households?

This is the same class of problems that households face when managing their budget. How can you keep your expenses inside the time and dollar envelope of your cash in-flows as your family grows?

This problem is not limited to young households. Retired households can have the same experience. Health care shocks come to mind for instance. The problem in all cases is related to the lumpiness and delayed feedback of expenses vs. income. However, while there can be a redemptive upside for home-run start-ups, can there be one – ever – for retired households?

This would suggest that retirement income plans need to factor in such lumpiness and delayed feedbacks.

Let’s close with two questions:

- Are traditional retirement plans built for the best of all worlds? Do they assume a precision (instead of accuracy) that comes easily from automated computation but that does not fit well in the daily experience of the real world?
- When real-life shocks hit your clients, in what ways do your products and processes allow for correction and adaptation?

To be continued…

Francois Gadenne