The Fragility of Income

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I don’t know when the next recession will happen but I know it will. One of my current preoccupations is contemplating the risk that the state and individuals run by deriving their income from singular sectors and sources.

I am currently reading Antifragile: Things that Gain from Disorder by Nassim Nicholas Taleb. It’s a very stimulating read. It has certainly forced me to consider my own financial circumstances. This post is largely my take on a number of concepts Taleb describes, specifically antifragility and optionality. These are related concepts and I discuss them in more detail below particularly how they pertain to the question of income.

The rest of this post is written on the assumption that you the reader have a basic grasp of these concepts. If terms like antifragility, optionality and black swan are alien to you, take a minute to read my notes on Antifragile here before proceeding.

According to the Irish Central Statistics Office (CSO), the average industrial wage for a full time employee in Ireland (as of last year in the CSO Yearbook of Ireland) is €45,611. Let’s consider a given individual with an income of a nice round sum of €50,000. Let’s assume that all of this income is coming from one source. For argument’s sake, let’s say this person is employed by a Financial Services company. On the face of it, this person is in a “good” job with apparent good prospects. I believe this would be a reasonably common view of this individual’s situation and prospects.

However this income is inherently fragile, come the next economic shock, the probability of this person losing their job would be high, suddenly they could have an income of €0. Just like 2008, this could happen overnight.

A better alternative than the above single income source scenario would be to have many smaller independent sources of income. I will illustrate this graphically below.

Let’s start by visualising the individual’s income as not just €50,000 but ten units of €5,000. It is inherently fragile due to it being concentrated into one source.

Figure 1: Fragile Single Source Income

50k_one_source

Next let’s now assume that this same amount of income can be achieved from a variety of sources as per Figure 2 below. This is now a less fragile situation. It might even be considered antifragile although one cannot simply assume that multi-source implies antifragile.

Figure 2: Less Fragile Multi Source Income

50k_five_sources

You will probably have noted that simply taking one source and dividing by five is not realistic. Let’s instead look at a more realistic transition from fragility to antifragility and what that path might look like. Starting again from Figure 1 (which represents a position of fragility), Figure 3 shows what a less fragile state would look like. For argument’s sake, let’s assume that this represents an achievable reality in one year. The additional sources 2 and 3 are relatively small but are growing (green), the original Source 1 is static (grey).

Figure 3: Transitioning from Fragility

50k_two_new_sources

Over time, additional sources can be added, the picture will increasingly become a mixture of increasing and diminishing income sources. It can be reasonably stated that Figure 4 below represents something which is approaching robustness. Robustness implying that if any one of the below sources was to disappear overnight, then the situation would not be dire. Even if the €50,000 was to disappear than there would still be a total of €24,640 available. The removal of Source 1 would be a materially negative event but not terminal. Figure 4 also represents a better alternative than the scenario of the single source fragile state that we began from (Figure 1).

Figure 4: Approaching Robustness

50k_four_new_sources

Moving the dial forward again, Figure 5 now represents robustness, taking any one source out of the picture will not have a materially adverse effect on the general income picture. Even taking the largest two sources out of the picture would leave a healthy €36,760. You will also note that Source 3 has now begun to decline from where it was. Having many income sources will inevitably mean that some are growing and some are diminishing. This is expected and optimal. The purpose here is to have enough options that if one really explodes and goes through the roof, then you will have skin in the game and benefit massively. Alternatively, if one income source diminishes significantly or disappears entirely, it will not have a disproportionate impact. The more income sources available, the greater the absolute difference for each source from the previous snapshot. This volatility is welcome and valuable. It is something to be sought and embraced. It is both a warning signal and an indicator of opportunity.

Figure 5: Achieving Robustness

50k_seven_new_sources_Robustness

Given the fact that there are now seven independent income sources in play, optionality has increased significantly. Having several options provides limited downside and unlimited upside. Not only is this scenario a better defense against the removal of particular income sources, there is a better opportunity of benefiting asymmetrically from positive black swans. Let’s now introduce a positive black swan, you can see that Source 5 in Figure 6 below has increased by over five times from the last snapshot in Figure 5 from €13,446 to €70,837. This clearly demonstrates how due to the increased number and variety of income sources, the better an individual can benefit from unexpected upside. The rest of the sources are still in a slowly increasing or decreasing state.

Figure 6: Positive Black Swan

50k_seven_new_sources_+BlackSwan

Let’s now take our income picture and throw 2008 at it. 2008 was a classic black swan as few people knew how destructive the crash would be or whether there would even be one in the first place. Under these conditions, one would expect a general negative picture.  Looking at Figure 7, there are some significant decreases amongst most of the sources. However because of optionality, there are some income sources which have increased in these conditions. In every recession, there are counter cyclical enterprises which benefit or parts of the economy that are sheltered from an economic storm. Note that the original Source 1 has now gone to zero, Sources 3 and 4 have approximately halved with Source 6 about a quarter of what it was. Despite the significant destruction of income, the overall picture is still positive.

Figure 7: Next Recession (Negative Black Swan)

50k_seven_new_sources_next_recession

It is unrealistic to assume that there will be a positive black swan event before the next recession so let’s default source 5 back to the level shown in Figure 5. Even after the removal of the positive Black Swan impact on Source 5, there is still a grand total of €55,327 being generated from six sources in Figure 8. This is better than the initial situation at the start with one source generating €50,000 which in the meantime has gone to zero.

Figure 8: Next Recession (Remove Positive Black Swan Event)

50k_seven_new_sources_next_recession_less_+_black_swan

While the above numbers and description of the transition from fragile to antifragile are entirely fictional, it clearly demonstrates the stark contrast between having a single income source and having multiple income sources. The latter providing optionality and thus antifragility. The antifragility being the result of a net positive outcome from a large dose of volatility which in most scenarios would be viewed as a negative event yielding negative consequences.

Assuming that there is a sufficient diversity to the above sources, the probability of them all going to zero at the same time due to the same event is much lower than the odds of any given source being adversely effected. It should also be noted that the amount of income derived from a given source or its recent growth has no bearing on whether it is likely to go to zero or not.

Furthermore the general antifragility of the individual’s income situation is undermined where the income sources are derived from the same sector or have inbuilt dependencies on each other or indeed one general common dependency.

In closing, I believe that the establishment of an antifragile income situation is advantageous and indeed necessary in today’s world.

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