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Dealing with Uncertainty and Risk from the Best Risk Mind I Know · Budget Your Business

0:00
Scott: Hello, and welcome to Budget Your Business, the podcast for small business owners who want to learn how to financially plan for every aspect of their business.
0:09
Scott: I'm your host, Scott Geller.
0:12
Scott: Today I'm joined by James Long or Palomar.
0:15
Scott: Hello, James.
0:16
Scott: Thanks for joining us.
0:17
SPEAKER_00: Hey, Scott.
0:17
SPEAKER_00: Thanks for having me on.
0:18
SPEAKER_00: Appreciate it.
0:19
Scott: Yeah, absolutely.
0:20
Scott: We've known each other for a long time here.
0:23
Scott: But uh for folks from me for the first time, could you share a little bit about who you are and what you do?
0:29
SPEAKER_00: Yes, so I've got kind of an unorthodox background.
0:33
SPEAKER_00: I'm currently uh Chief Technology Officer at Palomar Specialty Insurance.
0:38
SPEAKER_00: Uh that does not tell one as much about my background as you might think.
0:42
SPEAKER_00: My background is actually through uh the intersection of financial risk management uh in publicly traded large corporations uh and largely through the overlap of risk and risk modeling and technology.
0:57
SPEAKER_00: Now that that that is what opened the door to technology and resulted in me being CTO at an insurance company.
1:04
SPEAKER_00: Uh but as I like to joke with folks here, this is my very first job in tech was as CTO.
1:09
SPEAKER_00: But of course, it wasn't my first job running software development teams or you know working with code or all that.
1:14
SPEAKER_00: I've been doing that for 30 years.
1:16
SPEAKER_00: But this was my first job officially on the IT side of the house.
1:19
SPEAKER_00: All the rest of it was in risk and risk management.
1:22
Scott: Okay.
1:23
Scott: And this is not your first podcast or speaking opportunity.
1:26
Scott: I mean, what what are your typical areas of focus when when you're presenting or speaking?
1:31
SPEAKER_00: Sure.
1:32
SPEAKER_00: So I've written a book called the R Cookbook, uh, second edition.
1:35
SPEAKER_00: R is a statistical programming language.
1:38
SPEAKER_00: Uh, and so as a result of writing that book, I've gotten a number of podcast interviews to talk about uh statistical computing, and I periodically get involved or get invited, sorry, to speak at conferences, usually related to open source software.
1:53
SPEAKER_00: I think the intersection of people who are highly technical and also reasonably articulate, maybe a uh small overlap in the Venn diagram there.
2:03
SPEAKER_00: So I get a I get a lot of invitations to uh talk about that and philosophy around risk management as well as software development and uh a host of nerdy things like that.
2:13
SPEAKER_00: I re regularly speak at some technology meetups.
2:17
SPEAKER_00: Uh I'm I'm a number of meetups, including the the New York Open Statistical Meetup.
2:22
SPEAKER_00: I'm one of the folks they call if a speaker cancels, and I get invited just to come talk about whatever I'm working on.
2:27
SPEAKER_00: So that's my usual audience.
2:29
SPEAKER_00: A little different than this audience.
2:31
Scott: It is a little bit.
2:32
Scott: And and and so James, you and I met, we worked together back at General Financial when it was I think a Fortune 200 insurance company at the time, and and you moved on to reinsurance re which is about 9 billion, and that's a B uh written gross written premiums, if I'm not mistaken.
2:52
Scott: And and based on your experience, it's not exactly a resume for a small business.
2:59
Scott: At the same time, you know, if I looked on your LinkedIn, it says for you, James, your superpower is thinking probabilistically, understanding risk, and communicating clearly.
3:11
Scott: And another term that I saw and I I know just from knowing you is context.
3:16
Scott: And to me, that's very important, being able to put things in context.
3:19
Scott: And that's really why I asked you to come on the podcast, because you're one of the best minds that I know around evaluating and dealing with risk at the same time being able to talk to it in a in a real uh uh you know an understandable level or a level that that people can understand, which is not always the case with people that worked at reinsurance.
3:42
SPEAKER_00: Well, that's a big compliment.
3:43
SPEAKER_00: I will tell my wife and daughter you said this because they don't believe that to be true.
3:49
Scott: Great, fair enough.
3:51
Scott: And so the the reason I asked you on, James, is really to share with us and share with the listeners that are small business owners the mindset that they can take to think about risk within their business.
4:03
Scott: And I know you even have a little bit of background in small business yourself, right?
4:07
Scott: Even if it wasn't professionally.
4:09
SPEAKER_00: Right.
4:09
SPEAKER_00: So I so I grew up on a on a family farm.
4:12
SPEAKER_00: Uh my father retired from the Air Force uh when I was young, and we we moved and and farmed with my um my mother's family, my my maternal grandparents, and and we ran two operations, a farm and a uh seed business, so seed uh retail and wholesale.
4:31
SPEAKER_00: So certainly grew up in you know the the world of small business and cash accounting and uh that sort of business.
4:40
SPEAKER_00: And then most of my professional career has been, you know, in if not Fortune 500 companies, um, you know, at least that that uh publicly traded company scale.
4:52
SPEAKER_00: Uh the longest, as you mentioned, I was with Renaissancerie for 15 years, uh, and then now and then now with with Palomar.
5:00
SPEAKER_00: Um and let's see, where was I going with that?
5:02
SPEAKER_00: What is the question you asked me?
5:03
SPEAKER_00: That was the bad question.
5:04
Scott: Sure, I'm not sure if I did.
5:05
Scott: I think I just threw that out there.
5:06
Scott: But let's go ahead and start and jump in so I can start uh picking your braid about things here, James.
5:11
Scott: Yeah, you bet.
5:12
Scott: And what I'd like to just start with is what is risk, what does that word mean to you?
5:18
Scott: And and yeah, particularly in the world of business here.
5:21
SPEAKER_00: So there's a number of ways to answer this question, and and it isn't one that there's an absolute right way.
5:28
SPEAKER_00: I try to make a very specific distinction when I have these conversations.
5:33
SPEAKER_00: And it's a distinction that I learned from the economist Frank Knight, uh, who was a Chicago economist, and he framed he framed the problem as the dip as the delta between uncertainty and risk.
5:48
SPEAKER_00: And the way he defined risk was you don't know the outcome you're gonna get, but you understand the distribution.
5:56
SPEAKER_00: So if I tell you I've got a box and it's half white marbles and half black marbles, and tell you to draw a line, you don't know what the outcome is gonna be.
6:06
SPEAKER_00: It's either a white marble or black marble, but you do know what the odds are.
6:11
SPEAKER_00: And you know, you can draw from that box with some confidence it's gonna be one of those two things in about even proportion.
6:18
SPEAKER_00: And if I tell you to go out into uh, you know, the state of Virginia and measure 30-year-old adult heights, you know what distribution.
6:30
SPEAKER_00: You know, that's a well-defined statistical distribution.
6:32
SPEAKER_00: It's gonna be normally distributed.
6:34
SPEAKER_00: We can have a reasonable uh idea what the mean and standard deviation of that distribution is gonna be.
6:39
SPEAKER_00: Now, that does not tell us what any individual's height is gonna be.
6:43
SPEAKER_00: It's it's unknown, but we know the distribution.
6:45
SPEAKER_00: All right, that's risk from the Frank Knight uh way of thinking about it.
6:49
SPEAKER_00: The other side, uncertainty, is things that we maybe you don't know the domain of things we're sampling from.
6:57
SPEAKER_00: We don't know what all the possible outcomes are, and we certainly don't know the distribution.
7:02
SPEAKER_00: So it might be I stick a box out in front of you and say, pull something from the box.
7:06
SPEAKER_00: Well, you don't know what's in the box.
7:08
SPEAKER_00: You don't know what the distribution of things in the box is.
7:10
SPEAKER_00: And even if I tell you, well, there's marbles in there, you have no idea if you're gonna what color marble?
7:14
SPEAKER_00: Are they all the same?
7:16
SPEAKER_00: Are they rainbow marbles?
7:18
SPEAKER_00: Are there steel marbles?
7:19
SPEAKER_00: We don't know.
7:20
SPEAKER_00: And if we think about our business, small business, large business, it doesn't matter.
7:25
SPEAKER_00: We have a number of things that we can put a pretty reasonable distribution around because they're kind of well behaved.
7:31
SPEAKER_00: Uh we we can make some reasonable assumptions about interest rate, windows of movements.
7:36
SPEAKER_00: We don't know what it's gonna be, but we kind of know what some normal ranges are.
7:40
SPEAKER_00: And then there's a few things like the um, you know, pandemic.
7:44
SPEAKER_00: We we really don't know what the return period or the probability of another pandemic is.
7:50
Scott: Uh that's exactly what I was thinking, James.
7:53
Scott: Is the the pandemic, like that that's an example of an uncertainty there.
7:57
SPEAKER_00: Yeah, so so that's really uncertain, or these the and uncertainties aren't all you know catastrophic either.
8:05
SPEAKER_00: You can you can have it's just something that we don't know what the probability of it is.
8:09
SPEAKER_00: Now, I spend most of my life trying to tease things into those two buckets and then choose lines of business and work where the uncertainty is manageable and the risk is definable.
8:26
SPEAKER_00: So I guess by definition, if it's risk, if it's risk, I'm saying it's definable.
8:30
SPEAKER_00: Um, but you know, when I when I have worked on reinsurance deals, we would have two deals come where one has a lot of uncertainty and a component of risk, and the other has little uncertainty and a different risk.
8:43
SPEAKER_00: What folks will often do, and I watch this over and over, is they'll ignore the uncertainty piece and obsess over the part they can measure.
8:51
SPEAKER_00: Because folks, you know, there's something there that can be measured.
8:55
SPEAKER_00: We want to measure it.
8:56
SPEAKER_00: And you know, I would have work with actuaries who would split hairs over the third decimal point while only on the risk side, while the uncertainty side was half of the deal.
9:07
SPEAKER_00: And I'm like, it doesn't matter what what you do over there, the risky piece, if the uncertainty dwarfs it.
9:14
SPEAKER_00: So this is part of the the you and I had a conversation about context.
9:18
SPEAKER_00: This is context, you know, putting it in the context of what really matters.
9:22
SPEAKER_00: Now, when I get the when I'm pretty sure the uncertainty part is manageable, maintainable, at least understood how big it can be, and then we're left with a risk piece, then we can really get serious about risk modeling.
9:34
SPEAKER_00: But it's kind of like you got to make sure that's a meaningful part of the I need a collective term for both risk and uncertainty, for the, I guess we'll just call it variance.
9:43
SPEAKER_00: So, you know, the the re if you're sure the reasonable part of the variance is the risk, and you can put a distribution about that, then you can start doing methods, both simple and sophisticated, to get comfortable with that risk and maybe even do a process I call buying out the tail.
10:03
SPEAKER_00: And that's the process of protecting yourself from the downside.
10:06
SPEAKER_00: That may be buying insurance, it may be buying a financial hedge against uh negative financial outcome.
10:13
SPEAKER_00: If you're an insurance company, it means buying reinsurance.
10:15
SPEAKER_00: Uh, but you're gonna try to protect yourself from the downside using some sort of you know financial mechanism or maybe just preparedness.
10:23
SPEAKER_00: You physically prepare yourself for that risk so that if it happens, uh it's not as big a deal.
10:28
SPEAKER_00: But that's only after I'm sure the uncertainty is uh is in a manageable size box.
10:34
Scott: Right.
10:34
Scott: And buying out the tail, I I like that that that wording there, especially I just had uh Warren Fiske on.
10:41
Scott: He's a he's a cyber insurance broker that focuses on cyber insurance.
10:46
Scott: Yep.
10:46
SPEAKER_00: Yep.
10:47
Scott: And talking to him about you know, that that's to me, that's kind of the protecting yourself from the huge upside or downside, right?
10:57
Scott: Rather, not the upside, but but the the downside tail there is let's buy that specific type of cyber insurance, cyber policy, rather than just relying on a general EO or or just a general liability policy for your business, that's probably not going to cover it.
11:13
Scott: And and then you know that's gonna protect you from that, in this case, the tail.
11:17
SPEAKER_00: Right.
11:18
SPEAKER_00: Well, we actually, at the insurance company I work at, in addition to, you know, insurance companies write that line of business, but we also buy that line of business from other insurers, yeah.
11:30
SPEAKER_00: If if you're not in the business of writing that kind of business.
11:33
SPEAKER_00: And we went through this exercise, and what we discovered is if you exclude our cyber policy, um, our cyber risk policy, we have some meaningful exposure.
11:47
SPEAKER_00: But if you include our cyber policy, what ends up being left is um business interruption.
11:54
SPEAKER_00: So the big chunk of the remediation of a cyber attack uh on our insurance company would be covered by our cyber policy.
12:02
SPEAKER_00: But what that doesn't cover is we might not be riding premium for a week.
12:07
SPEAKER_00: And so that type of business interruption is what we're left with.
12:11
SPEAKER_00: So you could conceptually say we we've bought out the tail, we've taken the worst scenarios out, but it also changes the risk we're left with.
12:18
SPEAKER_00: Um and that's for us to figure out how to manage, and we probably won't manage that through a financial product, we'll manage that through operations, making sure we can operate uh in the event of a cyber attack.
12:31
Scott: Right.
12:32
Scott: So let me throw out another example, and and this is I think this is a common one for small businesses where let's say the majority of their business comes from one client.
12:40
Scott: All right, that's that that's a pretty common situation.
12:44
Scott: 70 to 80 percent of their business comes from one or two large clients, and they think about okay, you know, this is great, I've got one huge, one large client.
12:52
Scott: To me, that that's a risk, right?
12:54
Scott: That that's what if you lose that one client and the the impact of that to the business.
13:00
Scott: But in your in your if you're classifying this, would you classify that more as a risk or say an uncertainty?
13:05
SPEAKER_00: So we know it's a source of variance, right?
13:08
SPEAKER_00: So it in general, we would in the vernacular call that in my world concentration risk.
13:14
SPEAKER_00: Uh, but your question about is it risk and uncertainty is one of can you quantify it?
13:18
SPEAKER_00: Um and can you speak to the probability of it?
13:22
SPEAKER_00: And at first blush, you might not be able to, but if you think about it, you may be able to understand some facets of the risk distribution.
13:35
SPEAKER_00: So does this client have a history of changing vendors for your type of relationship?
13:43
SPEAKER_00: Are you married to the CEO's daughter?
13:47
SPEAKER_00: Right.
13:47
SPEAKER_00: There's a number of things that are going to change the probability of you losing that vendor relationship.
13:54
SPEAKER_00: And if you can work through that and come up with some kind of understanding of the probability of losing them, or I guess when we talk about losing them versus not, it's binary.
14:07
SPEAKER_00: In reality, most folks, it's probably continuous.
14:10
SPEAKER_00: It's like they may pare down 50% and I may lose half of my business with them, or they might.
14:16
SPEAKER_00: It's really another piece of uncertainty is they may want, you know, I see this with consultants, they may want to double my activity, and I don't have enough consultants to double my activity with them.
14:25
SPEAKER_00: So I'm I'm unsure on the upside, my ability to service this client.
14:30
SPEAKER_00: It's possible you can get your arms around that and and look at the probability.
14:34
SPEAKER_00: If you literally can't, it's completely opaque to you.
14:38
SPEAKER_00: They are, you know, you're a very small company, they're a very large company, and you've got no tight relationship with them, and they're 75% of your business, and you have no idea what factors would drive them dropping you, it's probably uncertainty.
14:53
SPEAKER_00: Right?
14:53
SPEAKER_00: You can't even begin to speculate what uh uh what your what's your probability of losing them or their business size changing, and especially if you've been with them not very long, you've been with them one year, or even worse, you've been with them five years, and each year they change what they're getting from you by a reasonable amount, uh, huge amounts of uncertainty there.
15:14
SPEAKER_00: So uh in that situation, yeah, we we vernacularly call that concentration risk, but whether it's concentration risk or concentration uncertainty kind of speaks to how much do you know about it.
15:24
Scott: Gotcha.
15:25
Scott: And I liked how you talk through that kind of almost in steps there, James.
15:29
Scott: In general, if I if we just kind of take a little bit of a step back, how could a small business owner go through the process or what kind of process or steps could one walk through to when they're evaluating this type or a similar type of risk or uncertainty?
15:46
SPEAKER_00: So almost almost every decision that we make is easier if we can turn outcomes into dollars.
15:58
SPEAKER_00: So I generally start with what what I will call what sounds mysterious, a bus a model, an Excel model, spreadsheet model, some kind of model.
16:09
SPEAKER_00: All that is is like here's the inputs, here's the outputs.
16:13
SPEAKER_00: You know, and the and the output ideally should be all the way down to net profit, if that's your most important metric.
16:20
SPEAKER_00: Most you know, small businesses, I think that's their most important uh metric is net profit.
16:25
SPEAKER_00: So you start with the things you care about, the the inputs, you have a number of factors in the middle, and then you spit out some sort of net profit measure on on the other side.
16:36
SPEAKER_00: And you know, you probably want to carry this across multiple quarters because most of this stuff has some kind of pattern to it, and you're wanting to see how these patterns uh would react to different events.
16:47
SPEAKER_00: So if you start with that, you can start playing really basic um games of change this number and see what happens.
16:56
SPEAKER_00: And in an in a visceral kind of way, that's a really good way to begin to understand your business, is just start with a spreadsheet model.
17:05
SPEAKER_00: When I want to understand a new insurance product, literally, either myself or I'll have an analyst, make me a spreadsheet model of how this insurance product works.
17:14
SPEAKER_00: Show me the now.
17:15
SPEAKER_00: Often I'm interested in stuff that's a little bit different than like the average person buying it.
17:21
SPEAKER_00: I may be interested in how does the premium earn over time?
17:24
SPEAKER_00: And how does the the written premium versus the earned premium work over time?
17:29
SPEAKER_00: Because this isn't obvious to me.
17:30
SPEAKER_00: How does this work with this reinsurance contract on it?
17:33
SPEAKER_00: But each business is similar, right?
17:35
SPEAKER_00: You got something you can put in and you can look at it over time.
17:38
SPEAKER_00: If you just start with that, and then you you you know, sometimes it starts with literally writing out a napkin of what do you think are the big factors, then you put it on in a spreadsheet, and then you can start playing with the numbers.
17:48
SPEAKER_00: And then after you got a spreadsheet where, oh, I can change the inputs and I can see how that changes, you know, every quarter over the next five years or whatever, then you can get into what what I call high, medium, low uh analysis.
18:01
SPEAKER_00: And this is you just usually what people do is they will either their first go at it is either how they hope it goes or how they think it'll go on average.
18:12
SPEAKER_00: That's usually what people do.
18:14
SPEAKER_00: So it's either average or high, is what folks will put in their first go uh at this.
18:20
SPEAKER_00: And that's fine.
18:20
SPEAKER_00: You just got to get the spreadsheet work.
18:22
SPEAKER_00: And then you will come in and say, what if we have a bad year?
18:26
SPEAKER_00: For some definition of bad.
18:28
SPEAKER_00: I don't know what bad looks like in your industry.
18:30
SPEAKER_00: Is it input cost way up?
18:31
SPEAKER_00: Is it a labor shortage?
18:33
SPEAKER_00: You know, is it the cost of milk triples and you make ice cream?
18:37
SPEAKER_00: I don't know what it is, but you put into your spreadsheet that shock value of that, you know, and your spreadsheet has quarters, so maybe you carry that forward and say, okay, after, you know, after six months it normalizes back.
18:50
SPEAKER_00: So you got a whole pattern.
18:51
SPEAKER_00: It's it's high and then it normalizes back, or it normalizes to 25% above the historic average, and you can begin to look at what this looks like.
18:59
SPEAKER_00: So you do a you do an average scenario kind of where I would expect based on what we've seen in the past.
19:04
SPEAKER_00: That would be average-ish.
19:06
SPEAKER_00: And then we put in a good scenario, better than expected, kind of something you wouldn't expect to see, but every five to ten years.
19:15
SPEAKER_00: You put in a bad scenario that's something you wouldn't expect to see, but every five or ten years.
19:20
SPEAKER_00: And now you kind of got a high, medium, low.
19:23
SPEAKER_00: Um, and you know, you may find you're going bankrupt on your low output.
19:30
SPEAKER_00: Well, if your business is not postured to survive a one out of five or one out of ten scenario if you're going bankrupt in that scenario.
19:40
SPEAKER_00: That's good information to have.
19:42
SPEAKER_00: Most of us and most of our spouses do not want to play that game.
19:46
SPEAKER_00: That's not a scenario they want.
19:48
SPEAKER_02: No, you don't.
19:49
SPEAKER_00: So at that point, you need to think, okay, what do we do about this?
19:52
SPEAKER_00: You may find that you're making money in your negative scenario, you know, but you can't pay for your children's private school.
19:59
SPEAKER_00: And that's important to you.
20:00
SPEAKER_00: Okay, you're getting paid, but you're not getting paid enough.
20:03
SPEAKER_00: Uh, so that's a start of good conversation and figuring out what what to do.
20:09
SPEAKER_00: Now, I I usually take it forward and forward and say, what's a like a one in five to ten isn't that bad.
20:16
SPEAKER_00: I'm 52 years old, right?
20:18
SPEAKER_00: I've seen 10 of those one in fives.
20:21
SPEAKER_00: Right, right.
20:22
SPEAKER_00: I don't, I feel really young, uh, despite the gray hair in my beard.
20:26
SPEAKER_00: I feel young.
20:26
SPEAKER_00: So, you know, one in five, or you know, and I've had five one in tens.
20:30
SPEAKER_00: Those aren't that uncommon.
20:32
SPEAKER_00: So maybe I should start thinking about what's a bad, bad day.
20:36
SPEAKER_00: Like what's the worst scenario I would expect to see in my lifetime?
20:40
SPEAKER_00: So, not an asteroid hits the earth, but you know, I have seen in my lifetime double-digit interest rates twice.
20:50
SPEAKER_02: Right?
20:50
SPEAKER_00: So maybe 15% interest rate is a once-in-a-lifetime event for me, or 12.
20:56
SPEAKER_00: I don't know, but it's something more than eight.
20:58
SPEAKER_00: You know, so put a big number in there if you're sensitive and interest rates.
21:01
SPEAKER_00: So try to figure out what's what's bad, but you wouldn't be completely unreasonable to see in your lifetime.
21:07
SPEAKER_00: And then similarly, on the upside, put a scenario in that's better, that's that much better than normal.
21:14
Scott: And and James, you know, just to uh say something there with with the you know that I agree.
21:20
Scott: I I I kind of think about it as a road, right?
21:22
Scott: If you know where the curves are, you have an idea when you're gonna hit something.
21:26
SPEAKER_00: Right.
21:27
Scott: And you know, the good I love the good and the bad.
21:31
Scott: At the same time, sometimes that that good scenario can end up being a bad scenario.
21:36
Scott: If you're growing, if you're ex if you're growing so fast you're running out of cash, yeah, all of a sudden that bad that great scenario turns into your bad scenario.
21:46
Scott: And I don't think a lot of companies really think about that aspect.
21:50
SPEAKER_00: Yes, no, that's a that's a good point.
21:51
SPEAKER_00: You get other parts, what you're really doing is stress testing your system.
21:55
SPEAKER_00: If you look at that good scenario and you're like, we will have.
22:00
SPEAKER_00: Like we will get overwhelmed by cash flow, even though we have future cash flow coming, that makes it look like we're going to be really profitable, you know, in quarter five of this scenario, because of our lag in our payout pattern.
22:13
SPEAKER_00: In quarter five, we drown in cash flow problems.
22:18
SPEAKER_00: Uh yes, that that's pretty classic um financial modeling for cash flow needs, right?
22:25
SPEAKER_00: Um and and yeah, you you've got to that the that's the advantage.
22:29
SPEAKER_00: Like I don't say just do the downside, right?
22:31
SPEAKER_00: I always talk about do the downside and the upside, is you learn something in the upside, right?
22:36
SPEAKER_00: Now, what you may learn is you have cash flow problems during high growth.
22:40
SPEAKER_00: That's very important, though.
22:41
SPEAKER_00: And you gotta make sure your model shows that.
22:43
SPEAKER_00: The other thing you may learn is the upside isn't good enough to compensate you or to allow you to sock away enough reserves to make up for the downside.
22:55
SPEAKER_00: And that's something you have to get comfortable with as a business owner.
23:00
SPEAKER_00: Uh some people are incredibly optimistic and just assume they're gonna, you know, they live in Wake Lake Wobagon, everything's gonna be above average, right?
23:09
SPEAKER_00: Everybody's gonna be in it, every year's gonna be above average.
23:11
SPEAKER_00: I, you know, I work in agricultural uh crop insurance, and I hear farmers tell me, we'll ask like scenario generation, what do you think your worst year will be?
23:20
SPEAKER_00: And they will give me a number that's better than the worst year they've experienced in their lifetime.
23:28
SPEAKER_00: And I'm like, how is that like uh I will ask them for like what a what the what a worst year they can expect is.
23:33
SPEAKER_00: I said that wrong.
23:34
SPEAKER_00: We'll ask them what the worst is, and they'll give me something that's better than the worst they've experienced.
23:38
SPEAKER_00: And it's like, despite how they talk, they're eternal optimists when they operate.
23:42
SPEAKER_00: And a lot of small business owners are this way.
23:44
SPEAKER_00: They're really eternal optimists.
23:45
SPEAKER_00: Yeah, absolutely.
23:46
SPEAKER_00: And that keeps them what's in there.
23:47
SPEAKER_00: Now, to talk to them, they're not gonna let you think that.
23:49
SPEAKER_00: A lot of them aren't.
23:51
SPEAKER_00: But you know, I I watched when I was living in Lexington, Kentucky, I watched um the someone was putting in a salon next door to my house, and they were all in.
24:00
SPEAKER_00: They had signage, they had signage on all the side of the trucks, they did the build out, and that business was not open three months.
24:11
SPEAKER_00: And I'm like, wow, they spent at least two months doing a build-out.
24:17
SPEAKER_00: Somebody didn't model cash flow.
24:19
Scott: Exactly.
24:21
SPEAKER_00: To only last three months.
24:23
SPEAKER_00: You know, they spent more time on branding and making sign, you know, um magnetic signs to put on the side of their vehicles, thinking I think they're advertising their business, but they didn't have enough cash flow to last three months.
24:36
Scott: Yeah.
24:37
Scott: It's like that that's an exact excellent example, James, of being too optimistic and not realizing how far your runway actually is.
24:45
Scott: A common common conversation I have as well.
24:48
Scott: So, James, you you took us through some some great steps of how to how to evaluate risk, which is absolutely needed, but without the decision-making part, it's only part of the part of the equation, part of the path.
25:01
Scott: So, how do you think about or how do you recommend the decision making once you you you've evaluated and maybe quantified some of the risk?
25:09
SPEAKER_00: Yeah.
25:09
SPEAKER_00: So, so I think about this because I still have family involved in production agriculture.
25:14
SPEAKER_00: We think about this when when pricing out um futures prices for forward delivery of grain or whatever they're producing, and also they're buying you know crop insurance.
25:26
SPEAKER_00: And one of the questions that that comes up pretty regularly is I want to put a floor in and protect myself, but I don't want to give up all the upset.
25:39
SPEAKER_00: And so that's a decision-making.
25:41
SPEAKER_00: So we understand what the distribution outcomes kind of could look like, they've got a basic model.
25:46
SPEAKER_00: Um, and we basically try to put a floor in that allows them to survive as a business and have enough cash flow uh to run the basic needs of the family, and so they'll do enough forward marketing to cover that, and that won't maybe be 100% of their crop.
26:07
SPEAKER_00: They'll leave some of that for an opportunistic pricing.
26:11
SPEAKER_00: So this is marketing, right?
26:12
SPEAKER_00: But the marketing is uh is trying to take risk off the table.
26:17
SPEAKER_00: The market doesn't care what your cost of production is, like that's an artificial floor, like the market can go well below your cost of production if you're a farmer because it the market doesn't care that it costs you a certain amount per bushel to uh harvest corn, you take your corn out of the ground.
26:33
SPEAKER_00: It just is pricing based on the needs and the market.
26:37
SPEAKER_00: So if you can go ahead and get a price locked in that guarantees a small profit, uh do that with part of your crop, and then give yourself uh part of it to uh speculate with uh going forward.
26:50
SPEAKER_00: And other businesses have different ways they can lock a floor in for the bad events.
26:57
SPEAKER_00: Maybe it has to do with using a fixed mortgage instead of a fixed loan rate instead of a variable loan rate uh on your business loan, or because you're concerned about the bad year, you change your lending terms to a longer time period, you know, 10 years instead of five for some you know startup expense or something, even though it looks like you should almost always be able to service the five year, you know you you've done that scenario, and that's where you get squeezed is servicing your debt.
27:25
SPEAKER_00: So go ahead and stretch it out longer.
27:27
SPEAKER_00: Uh maybe if you get five years into it and you haven't had the bad year, you can accelerate your payment on it.
27:34
SPEAKER_00: But that's an example of restructuring things to take into account what you learned when you did the scenario planning.
27:40
SPEAKER_00: Every individual business is going to have something different that they have to manage, right?
27:47
SPEAKER_00: So the the principle being here, I'm just talking about scenarios and how you quote unquote buy the tail out.
27:52
SPEAKER_00: If you can take part of that risk off uh using either a financial instrument, an insurance instrument, you know, changing a loan, um, having more cash uh as a buffer in order to take a uh scenario off the table, having a letter of credit from the bank uh in case a certain scenario happens, uh, or maybe it's having a contingency plan where if this event happens, here's how I am going to change my business and have it defined up front.
28:22
SPEAKER_00: Because if you try to figure that out when it's raining fire, you know, a whole bunch of companies wish they had had a COVID plan going into that.
28:32
SPEAKER_00: Nobody did because nobody, I didn't, nobody else, you know, had ever thought about a scenario quite like this.
28:36
SPEAKER_00: Actually, a little bit embarrassingly, I had thought about a scenario like this, and I completely missed the second order effects.
28:42
SPEAKER_00: Like I was fine, I got the first order effects right, you know, the number of deaths and all that.
28:47
SPEAKER_00: What I didn't get right was how the government was going to behave, how um interest rates would behave, how the stock market would behave, how how that would change the political climate.
28:58
SPEAKER_00: I didn't have a clue about anything.
29:00
Scott: You know, and that's a little bit harder to uh predict as well, there.
29:04
SPEAKER_00: Yeah, true, true.
29:05
SPEAKER_00: But it's like I didn't even I didn't even have it listed on my list of unknowns, how embarrassing this is, right?
29:11
SPEAKER_00: I mean, but it's one of those one-in-a-lifetime events.
29:13
SPEAKER_00: But what it taught me is the importance of a of a game plan.
29:17
SPEAKER_00: And so if you do some of this planning and you say, if if event A and B happens, we are gonna do this.
29:24
SPEAKER_00: And usually this is best if it's communicated to everybody running the company with you, whoever your trusted advisors are, whether they're family or third-party advisor, you know, have a number of things that, like, if this happens, we do this.
29:38
SPEAKER_00: And some of those things you commit to do are going to have to be hard.
29:41
SPEAKER_00: So it may be if this scenario happens, this is when we shut down our second location and drop back to one location.
29:49
SPEAKER_00: If you have two locations, you got to define that junk up front because in the moment, nobody wants to do that.
29:56
SPEAKER_00: It feels like losing, it's hard, it's embarrassing.
30:01
SPEAKER_00: And if you're left to make the decision when the cash is burning, you likely are not gonna pull the trigger because it looks like it's gonna get better in just a little bit.
30:11
SPEAKER_00: If we just stick this out, it's all gonna be okay.
30:14
SPEAKER_00: But if you have already defined up front, we're past that.
30:18
SPEAKER_00: We're to the point where now we need to sell to get our cash position such that we can hold on to the one location.
30:26
SPEAKER_00: I'm just using a hypothetical here.
30:27
SPEAKER_00: Right.
30:28
SPEAKER_00: But then you actually defend that one location, and if you just keep flying by the seat of your pants thinking things are just about to get better and you're gonna save both locations, you're gonna end up with no locations for your business.
30:42
SPEAKER_00: You're gonna live totally bankrupt.
30:44
SPEAKER_00: So a bunch of what this scenario planning does uh is help us get a game plan together to make the hard decisions when we aren't um as emotionally vested in what's going on.
30:59
SPEAKER_00: Well, we got our cool thinking hats on, we've got our advisor, we maybe have a family member who's in business with us, our spouse, or kid, and we're talking this through.
31:10
SPEAKER_00: And then we set those decision gates up, and we say when this gate gets tripped, this is what we're doing.
31:18
SPEAKER_00: Now, I'm a big fan of doing this not just in business, but in in my family, everyone has a living will.
31:24
SPEAKER_00: And the big value of it was sitting down and talking through with everyone what their desires are at end of life in the event of traumatic accident.
31:37
SPEAKER_00: And um, I am an extra strong believer in this because my my wife and I just went through this with her mother, and you know, we were not expecting the call, and we got the call from the ICU that said we're about to start kidney dialysis.
31:51
SPEAKER_00: And we had already talked about this, and my wife said, No, no, you're not.
31:55
SPEAKER_00: Yeah, because we had a plan for my this was my mother-in-law, and it's like you know, if if we had had to make that decision right there, the default would have been to continue escalated uh interventions for health, and that's what the emergency room and the ER defer to.
32:16
SPEAKER_00: And so you your tendency as a loving child or spouse or caregiver is going to be to go along with that.
32:24
SPEAKER_00: And this is like running a business.
32:26
SPEAKER_00: Status quo is kind of the default, and so you will not make, we will often not make hard decisions in the heat of the moment.
32:35
SPEAKER_00: We will go with the default.
32:36
SPEAKER_00: And the default is keep on going or do what someone is telling us to do in the case of medical professionals.
32:43
SPEAKER_00: But if you've thought this through and you have a plan, you can make the hard decision, you know, whether it's shut down locations, sell something, uh lay off employees, you know, or the case that we went through of you know, refuse dialysis.
32:58
SPEAKER_00: We need to doing the scenario planning up front allows us to make these hard decisions and have confidence that we are making the decision that we're committed to make and not and not be a stuck.
33:09
SPEAKER_00: It's still hard.
33:10
Scott: It is still hard, right?
33:11
Scott: I mean, personally, uh as well as business, to your point, when you know you you see the meme of the dog sitting at the table with everything on fire around here in terms of it's fine.
33:20
Scott: Yeah, sure, everything's seen there, right?
33:21
Scott: Everything's fine, everything's fine.
33:24
Scott: Yeah, it's it's not fine.
33:25
Scott: But if you've thought about it ahead of time, then you're prepared for that rather than making the the reaction in real time.
33:33
SPEAKER_00: Yeah, I think my wife got off the phone and I was right next to her when she had that call with the ICU nurse.
33:40
SPEAKER_00: And you know, I think it was I think I made the joke, kind of made that that joke like the um I think it's an insurance commercial where it's the life comes at you fast.
33:50
SPEAKER_00: I just looked at her, you know, and I said, well, life comes at us fast, you know, and gave her a big hug.
33:56
SPEAKER_00: And that's often what dealing with the downside of business is, and it's a whole lot easier if everyone in the small family business has had this conversation of what are we gonna do under these bad scenarios?
34:09
SPEAKER_00: And then we can do them.
34:10
SPEAKER_00: Under what conditions are we gonna lay people off?
34:13
SPEAKER_00: Under what conditions are we gonna close a location?
34:15
SPEAKER_00: Under what decision, under what conditions are we gonna say this decision was bad and we're gonna back it up?
34:21
SPEAKER_00: Now, the the one thing I left out of all this decision, all this discussion of decision, I want to go ahead and throw it in here now, is I'm also a big fan of, I think it was Jeff Bezos who talked about permanent decisions versus reversible decisions.
34:35
SPEAKER_00: And one thing that's a little bit maddening is watching people make reversible decisions as if they're permanent.
34:42
SPEAKER_00: So these this is what we call analysis paralysis.
34:44
SPEAKER_00: You know, they just are analyzing a reversible decision as if the end of the world depends on it.
34:51
SPEAKER_00: Um if it's easily reversible, just go try something.
34:55
SPEAKER_00: And if it doesn't work, back up, try, you know, do something different.
34:58
SPEAKER_00: Like that may be a marketing campaign, that may be, you know, a new product on your menu, if you're a restaurant.
35:05
SPEAKER_00: Some these are all small and easily reversible.
35:07
SPEAKER_00: Don't waste, you know, don't waste a long time.
35:09
SPEAKER_00: Actually, you probably benefit, do lots of experiments, see how fast you can try these different things and learn.
35:15
SPEAKER_00: On the other hand, if a decision is permanent, like taking a business partner or getting married and taking a life partner or um expanding a business into a new location or a new country, it's not impossible to reverse, but it's hard and it's expensive.
35:33
SPEAKER_00: Yes, it's yeah, and it's complicated.
35:36
SPEAKER_00: And for those, the level of analysis should be proportional to the difficulty in reversing decisions.
35:42
SPEAKER_00: If it's really hard to reverse, you should do a lot of extra research and make sure you really know uh what you're getting into.
35:50
SPEAKER_00: So a lot of times in business, uh, I talk about the permanent decisions versus the reversible, and and I think that's that was a Jeff Bees Bezos uh item.
35:58
SPEAKER_00: So that's a that's a useful rubric as well.
36:01
SPEAKER_00: Uh to hopefully, you know, I'm talking about all this risk and uncertainty and bad things and people dying and businesses closing and all this.
36:09
SPEAKER_00: Yeah, but if it's not that kind of decision, don't uh spend mental calories as if it is.
36:16
SPEAKER_00: And a whole lot of business decisions are.
36:19
Scott: Yeah, yeah, it is.
36:19
Scott: And I really like the one line you said there, James, of the level of analysis, and I think what you mean is level of time and and what you put into it.
36:28
Scott: So that level of analysis should be in level with the the difficulty to reverse that decision.
36:34
SPEAKER_00: That's exactly right.
36:35
SPEAKER_00: Yeah, yeah.
36:36
SPEAKER_00: And you know, we think about we generally think about the level of like impact.
36:41
SPEAKER_00: Like how big of a decision, is it a big financial decision?
36:44
SPEAKER_00: Well, if it's a big financial decision, but it's also easily reversible, you know, and I'm not sure what that what that would be, but maybe it's taking a delivery of something that you could turn around and sell on the secondary market for 98% of the value.
36:59
SPEAKER_00: Might be a big decision financially, but it's also pretty reversible.
37:02
SPEAKER_00: You know, if you're buying raw inputs that you could then turn around and sell.
37:05
SPEAKER_00: I'm I'm struggling for examples here, but I'm trying to take the decision-making criteria.
37:10
SPEAKER_00: People tend to fixate on the number of zeros, right?
37:13
SPEAKER_00: If it's a big decision, meaning lots of dollars, I should fixate for a long time.
37:16
SPEAKER_00: And I'm like, eh, it's actually a little more nuanced than that.
37:19
SPEAKER_00: It that's a component, but also the reversibility is a very big component.
37:25
SPEAKER_00: Taking a partner in a business may not look, you know, the the cash cost of that at the time you do it may seem relatively small.
37:34
SPEAKER_00: What's it gonna look like when your business is 4x what it is right now?
37:37
SPEAKER_00: Right.
37:38
SPEAKER_00: How hard is it to get out of that partnership?
37:41
SPEAKER_00: Uh, what happens when that partner you take on gets a divorce, and now your co-owned company is caught up in their divorce?
37:49
SPEAKER_00: Those are the type of difficult to reverse decisions that may not have a price tag on them that make that causes people to give them the level of scrutiny they deserve.
38:02
Scott: I agree.
38:03
Scott: I agree.
38:04
Scott: Well, James, this has been great.
38:06
Scott: Uh I like to wrap up all of our shows with one to three immediate takeaways that our listeners could literally put into action as soon as they turn out the podcast.
38:17
Scott: It might be something you've already mentioned, and that's fine.
38:20
Scott: What can you share with us today?
38:23
SPEAKER_00: I I think just the simple advice to do the high, medium, low scenario map of your business.
38:32
SPEAKER_00: So that means you got to have a model, a basic spreadsheet model.
38:36
SPEAKER_00: Then you've got to be able to put in a good scenario, an average scenario, and a bad scenario.
38:40
SPEAKER_00: Start with that if you haven't done that already.
38:43
SPEAKER_00: The, you know, you look at that, and that shouldn't be a super big lift.
38:47
SPEAKER_00: And then an awful lot of, but a lot of small businesses, in my experience, haven't done really that.
38:53
SPEAKER_00: They're just chugging along or they're just worrying about cash flow, not really thinking about the posture of the business under different scenarios.
39:03
SPEAKER_00: They're just like, how do we make sure we may have cash flow for the next year or the next few months?
39:07
SPEAKER_00: So just that high, medium, low scenario, and then map it forward for a few years.
39:12
SPEAKER_00: How do we survive?
39:14
SPEAKER_00: You know, how long can we handle certain downturns and begin to play with that?
39:19
SPEAKER_00: This doesn't require, you know, the the term you and I haven't used is uh Monte Carlo modeling, which is what I do for a living in insurance companies, right?
39:27
SPEAKER_00: This doesn't require that level of sophistication.
39:30
SPEAKER_00: It's more like have a toy in a spreadsheet where I can change inputs and see how it impacts my life.
39:37
SPEAKER_00: Uh now most people get exposed to this in like some sort of financial planning for retirement.
39:42
SPEAKER_00: Well, you're gonna need a little more uh sophistication in your spreadsheet for your business, but it's the same sort of thing.
39:48
SPEAKER_00: Put different assumptions in, put different uh levels of cash in, and figure out what happens.
39:53
SPEAKER_00: So just have a high, medium, low model in a spreadsheet uh is is a huge good starting point.
39:59
SPEAKER_00: And I also think just think about all the ways you might buy out the tail.
40:05
SPEAKER_00: I'm just hopefully I'm introducing an insurance-reinsurance term into people's vernacular about how much you buy out the tail.
40:11
SPEAKER_00: Sometimes buying out the tail is like insurance or you know, hedging or something, but sometimes it's just we're having, you know, financial advisors recommend six months of cash savings on hand.
40:25
SPEAKER_00: Um that's kind of to it, doesn't buy out the tail in terms of make it go away, but it's to survive the tail.
40:32
SPEAKER_00: So think about how how are you prepped for the tail, uh, prepped for the bad outcome.
40:37
SPEAKER_00: So I think those are those are two good takeaways, I think, for most small businesses.
40:42
Scott: Absolutely.
40:42
Scott: I I I agree, James.
40:43
Scott: I I uh I might use it as a commercial for myself because that's you're you're mapping out exactly what I love to do and work on.
40:50
Scott: Thank you.
40:50
Scott: Excellent, excellent.
40:52
Scott: One more ask here is I enjoy a good podcast or or book recommendation, and and I I know that you're an avid reader, and and I can only imagine how many podcasts you probably listen to.
41:03
Scott: So what what do you have for us today?
41:06
SPEAKER_00: Gosh, on on podcast, I probably listen.
41:10
SPEAKER_00: Well, I listen to dozens of podcasts.
41:12
SPEAKER_00: I don't listen to every episode of every podcast that I listen to, uh, but I'll dip in and dip out.
41:17
SPEAKER_00: I'll go over to Spotify and say, you know, who's got a new episode out, and then I'll pick one of the ten that I've got that week, and I'll listen to one or two on a flight.
41:25
SPEAKER_00: I've been enjoying the the heck out of um Money Stuff uh by Bloomberg.
41:31
SPEAKER_00: Um Matt Levine and uh Katie, and I'm drawing a blink on Katie's last name.
41:36
SPEAKER_00: She's a Bloomberg reporter, uh does the TV show during the morning.
41:40
SPEAKER_00: But their podcast, Money Stuff, is really good.
41:44
SPEAKER_00: And part of it is uh because Matt Matt Levine is such a good storyteller about financial things, and a whole bunch of this is about you know shenanigans of uh going on in in large businesses, but but it's also he makes the complicated financial things uh much more simple.
42:01
SPEAKER_00: It doesn't probably apply much to running small business, but I find it terribly amusing.
42:06
SPEAKER_00: So I highly recommend that.
42:08
SPEAKER_00: And he used to just write up a Bloomberg uh uh article, I'm sorry, column called Money Stuff, and they've just in the last six months or year or something started doing a podcast.
42:19
SPEAKER_00: So recommend that.
42:20
SPEAKER_00: Uh also recommend kind of uh Michael Lewis's podcast.
42:25
SPEAKER_00: I always enjoyed his writing of his books, and he's got uh podcast as well, so that's always worth listening to.
42:31
SPEAKER_00: Uh, in terms of books, the the book for the last couple of years that I've recommended more than any other, and it overlaps exactly with this topic we've been discussing, is Annie Duke's book, Thinking and Bets.
42:44
SPEAKER_00: Uh, Annie Duke was a professional poker player, but she's really a risk philosopher.
42:51
SPEAKER_00: And she can explain the concepts that she learned while learning to bet in poker and learning to play uh World Series of poker level poker games, how she learned to analyze her own decision making, how she learned to use a mentor to help her analyze her decision making, how to separate the outcome versus was it a good decision?
43:15
SPEAKER_00: Because sometimes we can make the right decision and have the wrong outcome.
43:19
SPEAKER_00: And that's one of the concepts that most lay people, when they're thinking about risk and uncertainty, they misunderstand.
43:28
SPEAKER_00: They take a gamble, and if it turns their way, they decide it was a good decision, and if it doesn't go their way, they decide it's a bad decision.
43:35
SPEAKER_00: That's not how that actually works.
43:38
SPEAKER_00: You know, what you want to do is line your life with taking the decision that's probabilistically in your favor, knowing that sometimes it won't go your way.
43:46
SPEAKER_00: And Annie talks about that in her book.
43:48
SPEAKER_00: So her that thinking in Betts is tremendous.
43:51
SPEAKER_00: She wrote uh another book after that called Quit about When to Stop Doing What You're Doing.
43:56
SPEAKER_00: And uh actually that was that book, coincidentally, I read right before I left um Renaissancerie after 15 years there to join a much smaller startup company.
44:06
SPEAKER_00: That may be coincidental, but it may not be.
44:08
SPEAKER_00: So I recommend I recommend all of her books.
44:11
SPEAKER_00: And and she's she's super smart and articulate and very clear and crisp in her thinking with good examples.
44:17
SPEAKER_00: So I recommend that.
44:19
Scott: Okay.
44:20
Scott: Well, this has been great, James.
44:22
Scott: It went right down where I I knew it would, you know, sharing with us your the way you think about risk and and applying it to the small business space.
44:31
Scott: This has been fantastic.
44:32
Scott: Thanks for coming on today.
44:34
SPEAKER_00: Well, you bet, Scott.
44:35
SPEAKER_00: I'm I'm glad I could join you.
44:36
SPEAKER_00: And you and I are so many ways doing very different kinds of business, but I feel like the same principles of how to think about risk, uncertainty, how to make good decision making, that's completely independent of the size or type of business you're running.
44:51
SPEAKER_00: So this has been a lot of fun to talk about.
44:52
SPEAKER_00: Thanks a lot, Scott.
44:54
Scott: Yeah, thank you.
44:56
Scott: If you like this show, check out more of your favorite podcast locations at Apple Podcasts, Spotify, Amazon, or others.
45:03
Scott: And please go out and rate the show.
45:05
Scott: If you found something useful in today's show, please share it with other business owners that might also find it useful.
45:12
Scott: I'm Scott Keller, and I hope you join me next time for budget your business.