Ruin-proof strategy
Understanding and limiting exposure to ruin is key to protecting against the unexpected.
The history of the world’s successful cultures is largely one of innovation: Those who innovate and invest in discovering the next great leap in technology and productivity are rewarded handsomely, while those who stagnate eventually dwindle into oblivion.
Successful innovation can lead to almost unlimited upsides, as we have seen in the completely transformative effects of inventions including gunpowder, steam, electricity, automobiles, modern medicine, and the internet.
The problem is that the path to innovation is costly and uncertain, and taking risks opens up people to loss. Since loss aversion is naturally stronger than the desire for rewards, this leads to a natural conservatism where people naturally prefer to hold onto the prosperity of today instead of seeking the next innovation of tomorrow.
Leaders of organisations and societies must therefore manage the paradox that the desire to remain prosperous trends towards conservatism, while obtaining prosperity requires continued innovation and exposure to loss.
Mere loss will not deter the more entrepreneurial among us, but worse than mere loss is ruin – death or irreversible loss. Ruin for an organisation can be similarly defined as either organisational death (ceasing to exist) or an irreversible loss of core capability.
The instinct to avoid ruin is a powerful motivator in people’s choices, and only a very few will knowingly hurl themselves into a future with a real and plausible chance of ruin.
This cuts both ways: So long as an individual’s fate is linked to an organisation’s, people will act strongly to ensure the continued existence of that organisation. On the other hand, once people believe an organisation is unavoidably facing ruin, many will seek to leave to avoid being caught up in the “sinking ship”.
Most modern societies have, on this basis, implemented two critical changes aimed at significantly dropping the risk of ruin for those involved in organisations:
Limited liability company – Known under various legal terms and found in both publicly-owned and privately-owned forms, a limited liability company operates as a distinct entity which cannot pass on its debts to its shareholders or owners (with some exceptions)
Bankruptcy – While bankruptcy law continues to evolve, the modern incarnation in which debtors can voluntarily apply for bankruptcy to be released from debts also mitigates the ruinous effects of financial losses, allowing people to “start fresh” and rebuild wealth after an otherwise ruinous outcome.
These pathways have the effect of altering the risk-reward balance for leaders of organisations, who no longer face personal ruin themselves (except in cases where they choose to engage in wilful negligence or fraud). Removing this nexus between individual and organisational ruin encourages realisation of the upsides of innovation without the downsides.
The broader balance of legislative rules and penalties to ensure that these constructs are implemented effectively and mitigate the risks of moral hazard is complex and goes beyond the scope of this article. We shall assume that such a regime is in place and that leaders are genuinely motivated to prevent organisational ruin through a degree of personal accountability or loss, despite not facing ruin themselves.
In this situation, development of a ruin-proof strategy for an organisation requires these steps:
Tolerance – Explicitly determine the ruin tolerance threshold for your organisation. This should be expressed as both the level of loss required to count as a ruinous event, and the chance of ruin occurring. Where the level of exposure to individuals and the organisation differs, it is also recommended to capture the maximum unhedged loss faced by organisational participants (ie the amount they can’t control), jointly or individually, in the event of ruin.
Identification – Systematically enumerate every plausible ruin scenario (defined as ceasing to exist, or suffering an irreversible loss) through well-known organisational planning techniques such as pre-mortems, red team exercises, and black hat thinking.
Quantification – Describe the combination of system and environmental indicators and variables that indicate a ruin scenario has occurred. Run future backwards exercises to identify horizon events where ruin becomes unavoidable and before that, reasonably plausible.
Treatment – Document the approach to be taken to effectively prevent or offset the possibility of ruin. The three main approaches are:
Elimination (preferable where possible) – Change the organisational strategy so that the ruin event literally cannot happen, no matter how unlucky. For example: Deleveraging of investments to prevent losses exceeding deposits, keeping sufficient cash on hand to continue operations even in the event of a catastrophic year-on-year sales outcome, or transitioning the organisation to a decentralised model with no single point of failure.
Hedging – Cap exposure through opposing or mitigating “bets”, such as convex investments (limited downside with unlimited upside from volatility), insurance/reinsurance, stock options, maintaining dual-supply chains. Hedging activity must cost significantly less than the expected loss (for example, aiming for 2:1 expected value or more), and must not itself create new ruin paths.
Contingency – Have a pre-prepared strategy that will steer your organisation away from ruin if events move beyond a risk threshold for a ruin zone, and pre-commit to the corrective actions to be taken to avoid potentially critical delays or prevarication from emotions or politics during the event itself.
Observation – Define objective thresholds that identify where your planning has been inadequate to prevent you drifting into a zone where there is a plausible risk of ruin (as per the previous quantification), and have an emergency response plan ready to enact if/when the thresholds are breached.
It is instructive to compare ruin-proofing against the sentinel event monitoring regime discussed in an earlier article. The goal of ruin-proofing is not risk elimination but a calibrated exposure to risk that sustains the innovation engine societies depend on. Leaders that sensibly guard against ruin maximise the potential for organisational and social rewards, while doing everything possible to prepare for the ‘black swan’ events that no plan fully anticipates.