Being Anti-Fragile
Demystifying What Liquidity Means
Unless you’ve been living under a rock, the news this week was all about a certain crypto exchange that failed in the matter of days. Details are still coming out and there may be some fraud, improper assets reserved and much more. But a lot of the problem comes down to one thing…Liquidity.
Let’s start with the definition, according to Webster’s Dictionary
Liquidity: the quality or state of being liquid
Liquid: flowing freely like water
Real helpful, thanks.
The nature of insurance companies, banks, and exchanges is the balance between having enough assets on hand to cover customer needs vs earning a return. Take for example an insurance company. You write insurance policies to various customers, in return you receive a premium. That premium is for the most part not needed immediately to fund claims. So the company can choose to invest that premium to earn a return. They can do so in short term treasury bills, longer term bonds, or maybe even in public and private companies and natural assets.
Here’s where regulation comes into play. As an insurance company, the natural incentive is to plow as much money as possible into higher earning assets so that the company earns more (pays employees more, higher dividends, more cash to reinvest in higher earning assets, etc, higher stock price, etc). However regulations make sure that this is restricted in terms of what assets they can invest in, how much of capital can be invested, how long can the duration of those investments be, and how much reserves the company needs to keep.
That doesn’t mean that companies don’t fail. In fact, Hurricane Ian in the US hit some areas of Florida so hard that many property insurers became insolvent and declared bankruptcy. However, with regulated entities comes local government and federal help to backstop issues. So the balance in regulation needs to be allowing companies to still earn a return while not incentivizing them to go wild earning that return because they know there’s a backstop (it’s a hard thing to do properly).
When companies operate outside of regulated areas, that all falls apart.
You can earn outsized returns but also the risk for both the company and customers is higher in a downside scenario.
Applying this to Personal Business Decisions
How does this apply to our lives?
Well first if you’re a founder, a lot of companies who raised rounds ahead of traction in 2020/2021 were asking boards if they could invest some of the cash in crypto. The answer from good boards is always, let’s make sure we’re in the most liquid option only. Perhaps in the future the most liquid option may be crypto, cash, or ….even bananas :) (look up Zimbabwe - with sustained hyper inflation the world flips back to a real barter economy). For now though, the answer is still cash.
That does not mean companies should not manage their treasuries. Banks and companies like Modern Treasury help companies manage their cash balances so that you can preserve liquidity while also earning a return on those assets (interest rates on deposits or even in some cases short term bonds).
Making sure that the company does not fail because of a liquidity mismatch is the most important thing. For example, a company could have a massive gain on a crypto position but still fail if they can’t liquidate to cash fast enough to fund operations.
This holds true for personal balance sheets as well!
I’m a big proponent of everyone who has the means, investing to earn more in the future. But beware of the liquidity mismatch. If you need to purchase a home in the next 1-2 years, cash or short-dated treasuries may actually be a better option then investing in the stock market for example.
Medical expenses are hard to budget for since they are accidents and unexpected. But keeping a reserve can help cushion the financial challenge when these things happen.
The worst thing that can happen is you’re invested in a bunch of long duration assets AND they have big gains BUT you have immediate cash needs. Those assets are hard to sell and if you NEED to sell then you’re going to have to sell in a distressed environment since the buyers know cash is an immediate issue. So the amount received for those assets will likely be a whole lot less than what they’re currently valued at. THIS SUCKs. Do not put yourself in this position.
Very smart people fall into this trap all the time as you can see from various events.
Approach your personal and business finances to be as anti-fragile as possible. Able to withstand the shocks and waves of the business cycles and come out the other side. Definitely still invest what you can, but be aware of what needs to be immediately liquid due to potential near term expenses.
This is why cash is king right now. Liquidity, ability to last, and being anti-fragile is more important than growing faster or earning a bit more on your assets.
Blowups and failures are always a time to learn rather than simply marvel at.
“Never let a good crisis go to waste.” - Winston Churchill while working to form the United Nations after World War II
Things I enjoyed this week:
Insane story about someone who survived suspected terminal cancer TWICE and also survived getting hit by a truck at 70mph while biking across America. If there’s one podcast you listen to this week, listen to this one.
This was truly a life-changing conversation to listen to From someone who survived severe cancer…twice and in between got hit by a bus @ 70mph Taught me how to appreciate the things we can do everyday, what perseverance looks like, and how to reframe your thinking when downIn this week's episode of 'Feel Better Live More, @jamesgolding1 explains how having cancer taught him who he was and what he was capable of. It changed his outlook, stopped him going through the motions, and made him realise there was more to life than material things. (1/2) https://t.co/rMwnnDsMBu
Dr Rangan Chatterjee @drchatterjeeukHow to do annual budgeting for CTOs/VP Eng from Karim Fanous, VPE of StrongDM and ties in well with Snack Bites post last week
Must read insights on investing from Todd Combs, CEO of Geico and one of Berkshire’s key investment professionals
Wouldn't "be as anti-fragile as possible. Able to withstand the shocks and waves of the business cycles and come out the other side." imply you would come out the other side stronger?
Aka having more liquidity than you think you need or than your peers hold gives you optionality when shocks hit. You get to go bargain hunting while they run and hide. This makes you grow stronger from volatility, vs being harmed by it.