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Navigating through Uncertainty

For many years, the notion that market behaviour and results can be foreseen has been a source of extensive academic discussion in economics. However, successful real-world businesses understand that the future is unpredictable. Therefore, they approach making decisions with this uncertainty in mind.

Neoclassical economics believes that we can predict and measure the outcomes of people’s decisions in the market by considering risks. In their book “Radical Uncertainty: Decision-Making Beyond the Numbers,” John Kay and Mervyn King demonstrated that this way of thinking has existed for a while. In economics, it is called “expected utility,” which assumes that rational economic agents always try to maximise their gains.

Both authors are well-prepared to study how financial markets and markets for actual goods and services interact. They have questioned the statistical methods and basic assumptions – that economists believe – can predict and control the future.

It all starts with Managing Expectations in a venture. For the past 90 years, economists like John Maynard Keynes and Robert Lucas have considered expectations a crucial factor in how markets work. But they have different views on how these expectations are made. Some believe the data follows stable and predictable processes, similar to physical laws governing light and gravity. On the other hand, some argue that the social processes driving markets make future outcomes highly uncertain.

Different theories about the market works have sprung up during this time. The Efficient Market Hypothesis says that financial market prices already consider all the important information.

On the other hand, The Real Business Cycle Theory of New Classical Economics believes that the overall economy naturally finds a balance and its markets work efficiently. While outside shocks can influence the system, they cannot be easily controlled or managed using fiscal or monetary policies.

Even after all the theories, the main question remains: How can we lessen the impact of uncertainty when we face situations where we just don’t know what will happen? What can guide our actions when we are dealing with uncertainty?

There can be three paths of solution; two among them are defensive, while the other is proactive. All three of them disagree with only caring about efficiency in distributing resources. Because of this, they do not follow the mainstream way of thinking in economics.

Cash and Control

The “cash and control” approach is designed to safeguard against uncertainty in venture capital and other financial areas. On a smaller scale, it ensures that if problems arise, you’ll have the money and authority to address them effectively. This approach provides both access to necessary funds and the ability to make essential adjustments.

The availability of cash and control depends on varying situations. In the recent Unicorn Bubble, a lot of money was available to entrepreneurs due to lenient monetary policies over the years. However, it became challenging for entrepreneurs to maintain control because many founders gained strong control by owning shares with extra voting rights.

The idea of having two classes of stock with different voting rights was initially seen in family-controlled media companies but later became popular in Silicon Valley, starting with Google’s first venture funding in 1999.

Influential venture capitalists like John Doerr and Mike Moritz supported this approach. After that, many entrepreneurs, like Google founders Sergey Brin and Larry Page, aimed to adopt this approach. Mark Zuckerberg, the founder of Facebook, also adopted this dual-class stock structure for his company, following in the footsteps of Google’s founders.

The consequences of agreeing to these conditions became evident through public fights, both in boardrooms and courts, where attempts were made to remove the founders from companies like Uber and WeWork. Now that the period of loose monetary policy has ended and the Unicorn Bubble has deflated, venture capitalists are again considering “cash and control” as an important factor in their decisions.


Market Power and Mercantilism

Outside of the startup world, in the core of big businesses, market power is a significant way to have control. Warren Buffett famously referred to this market power as a company’s “Moat.”

Numerous academic studies examine the growing market power in industries, particularly in the US. Market power leads to dominant positions and substantial profits for companies. The top four successful companies, initially funded by venture capitalists, now hold massive cash and short-term marketable securities: Alphabet with $115 billion, Amazon with $69 billion, Apple with $56 billion (plus $110 billion in long-term securities), and Microsoft with $104 billion (as of March 31, 2023).

These companies have embraced the fact that creating new products and services involves a lot of uncertainty about technology and whether people will buy their innovations. However, they are not willing to take any financial risks.

Keeping too much cash on hand during regular times and following strategies that accumulate excessive cash reserves are both departures from the ideal efficient approach. Economists have come to understand that in imperfect markets, it is reasonable for companies to hold uncommitted cash as a form of self-insurance, even though this practice comes with visible drawbacks.

Investing in Resilience

Investing in resilience means putting more money into specific areas strategically, even if it goes beyond what would be considered the most efficient way of producing goods.

The COVID-19 pandemic showed that long and complex supply chains were weak. These networks were designed to be highly efficient in using money but proved vulnerable in times of crisis. This happened just 12 years after the global financial crisis, which revealed that the efficient use of money in the banking sector made it less resilient.

In the banking system, for example, being resilient means having more money than usual, even if it seems excessive during regular financial times. Similarly, resilience in production systems requires extra stocks and backup sources.

The usual data that defines “normal” conditions and deviations may not help predict unexpected shocks, like natural disasters, pandemics, or geopolitical events, which can severely strain the system.

Working capital is the money a company invests in – things like inventories and the money owed by customers who still need to pay. The company can hold more inventories than usual to protect itself, even though it may reduce its profit from these investments. This reduction in profit is the cost of having this insurance.


Experimentation and Innovation

The third approach starts by acknowledging that innovation always faces significant uncertainty.

We might not try new and costly experiments if we always choose the safest and most efficient ways to use money. As a result, we could take advantage of innovations that have the potential to bring significant changes and improvements.

Experiments help us explore what we don’t know. Every new startup is like an experiment in the venture capital world, and many fail. However, competition in the market eliminates the failed startups and validates the successful ones. “Schumpeterian waste” process is essential because it leads to continuous progress, better productivity, and improved living standards over time.

‘Schumpeterian waste’ refers to the process of creative destruction, a term coined by economist Joseph Schumpeter. This process involves the continual cycle of innovation and obsolescence within a market economy. In uncertain times, it becomes essential as it clears the path for new and innovative ideas to emerge. While it may seem counterproductive to waste resources on ideas that may fail, this very process of discarding outdated or inefficient practices and products creates space for newer, more efficient ones to take their place. This ongoing cycle of creative destruction drives economic progress by allowing for the adaptation and evolution necessary to thrive in a rapidly changing world. It encourages the entrepreneurial spirit and promotes a competitive environment that fosters innovation, ultimately leading to the growth and revitalisation of the economy in times of uncertainty.

Author- Shiddhartho Zaman

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