Risk for Airplanes (Part 2)
Michael Raynor explores addressing risk in his work The Strategy Paradox. His work provides the most prominent way to operate in an environment filled with unknown variables.
His first step to addressing risk is to develop a set of all the foreseeable future possibilities. Although a time consuming process, it is important to consider all the possible future situations that might occur. What will inflation do? How will engine prices react? What will the rotable pool look like? What will the future price of new vs. old airplanes be? What will the future viability of your future overhaul look like?
It is important to note that you should not waste time developing future situations that differ on semantics. It won’t matter what football team wins the super bowl. What defines an important factor that needs to be considered vs. a semantic detail will depend on what the investment under consideration is. It is up to the professional owner/operator to make the appropriate decision concerning this.
After all of the possible outcomes have been determined, they need to be weighted with respect to the probability of their outcome. Although it is easiest, the use of a simple bell curve relationship is not necessarily the correct way to go about this. Inflation is far more likely to move in the positive direction than the negative direction. A bell curve wouldn’t accurately reflect this.
Now, an investment strategy needs to be constructed to address every possible future possibility. Again, this process will be a time consuming deed. However, it will not require the imagination required in the first step. Instead, this process requires repetitive and methodical calculations to determine the appropriate investment risk structure. This is where Howard Marks’ consideration of risk becomes important. When addressing different situations, it is important to consider the possible investment outcomes not on a straight line basis with respect to risk, but instead as a probability distribution.
When you consider this, it requires graphing on more planes than can be physically represented (3). Instead, it requires insightful analysis on the effect of one event on multiple others. Write down every assumption you make, and every reason you have to believe a situation will work out how it will.
Then pick the situation you foresee as most likely and implement that strategy.
After all of this, all you can do is wait and see how things actually play out. We can’t predict the future, and this methodology gives us a plan to deal with a variety of possibilities. As events play out, you can alter your strategy to reflect the actualities of a given situation.
The need to alter strategies, however, is where underperformance risk rears its nasty head. Changing strategies creates “friction,” or financial loss. Your broker will charge transaction fees, you may lose money in open market transactions due to those liquidity issues, and more time is lost without earning interest. Furthermore, as an airplane owner, you don’t necessarily want to spend your time dealing with these financial issues.
What we need is a shortcut that takes “friction” events out of the picture. The problem is that no job done right is done via shortcuts. As an airplane owner/operator you are obligated to live with the possibility of underperformance risk, and the resultant exposure to liabilities. Instead of a shortcut, a specialized product is required that helps you manage your aircraft’s inevitable financial liabilities.
This information provides the foundation of Gemco’s Overhaul Savings program structure. From market viability to investment structure, risk management provides the foundation to almost all facet of the program. So how does this all integrate into a complete story?
The key factor in addressing all the risks posed through aircraft ownership is by maintaining the most flexibility that you can without incurring debilitating additional cost. Usually additional flexibility comes at a premium. Imagine you’re at a horseracing track. If you want to bet on what order the first three horses will finish, you could just bet a trifecta (which would be predicting both the top three horses, as well as the order in which they finish), or you can “box” that trifecta. Now, you no longer need to predict the exact order in which the horses finish. All you need to know is the names of the top 3. Your odds of winning increase when you do this, of course, and your payout at the end will reflect this. Not only will you pay a premium price when you place your bet, it also will payout a lower amount. Your additional flexibility cost you additional cash.
It is rare to find anyone willing to offer you additional flexibility at all, let alone at a reasonable price. Relating this back to Gemco’s Overhaul Savings program, the additional flexibility offered via the ability to consistently access reserve account value while also building equity allows owners the ability to completely sidestep the issues of elasticity risk.
Gemco’s Savings programs have two main factors regarding investment procedures:
1. Client reserve cash is to be invested in only investment grade investment opportunities.
a.) This procedure acts to preserve initial account equity. It is possible to chase potentially higher returns with riskier investments such as equities, but reserve account investment timeframes do not justify additional risk. A 12-15 year timeframe does not provide ample time to cover the potential loses poised by a depressed or recessed market.
b.) However, investment grade quality investments are two pronged: government backed securities, and corporate securities. Gemco utilizes its own investment expertise to make the determination as to the most appropriate investment structure of these components and is beyond the scope of this article.
2. Client reserve is to be held in elastically advantaged accounts
a.) Gemco sidesteps elasticity issues via smart investment structuring. Individual owners are not capable of taking advantage of this because their reserve accounts lack the size required to permit this. Instead of just saving for a single overhaul, Gemco manages many accounts on top of the company’s own reserves. This gives Gemco the liquidity to make investments that mature at pre-determined dates. By not needing to sell assets before maturity, there is no liquidity risk.
By removing much of the concern revolving around elasticity risk, the potential for underperformance risk is practically zero. Now, the most important step to avoid not meeting our investment goals is to simply have a defined set of steps in place that lead where we want to go.
I run into people every day that claim they have a headache. Everyone has a different reason about why they have it, and the descriptions of the cause are usually in-depth. But, if we take the time to back up and take a broader view, I think you would be surprised to notice a simple trend: most people give themselves headaches.
Airplane owners are usually the worst offenders to the rule. Maybe our eyesight is clouded by romanticism, maybe we are just too busy to consider the actual implications of owning our aircraft, or maybe we are just too blind to see the truth. No matter the cause, the general aviation population, on the whole, is in the most risk it has ever been in.
The fleet of general aviation aircraft is increasing, and with it so does the outstanding maintenance liability of the fleet. Despite this, many owners continue to disregard risk, and plow forward with their plan.
Howard Marks’ thoughts on risk will probably will not earn him a Nobel Prize like Modern Portfolio Theory did for Harry Markowitz. Nevertheless, it provides an insightful foray into the complex economic and financial issues that govern aircraft ownership. Now is the time for owners and operators to start utilizing the tools at their disposal to turn the risks they face into possible tools that can give them increased financial security.
Many owners, however, do not want to think of their aircraft as an investment vehicle. By doing this they sidestep this whole conversation in its entirety; they act surprised when confronted with liabilities. Ignorance is certainly not bliss when it comes to airplanes.