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Liquidity: The Best Hedge in the Risk Thinker’s Toolbox

Posted in on
March 30, 2021

Author: Ron Dembo

Eggs in the basket; cash in hand; rainy day funds – whatever you like to call it, having liquidity is an easy hedge against the unknowable risks of a radically uncertain world.

When I started my former company, Algorithmics, I remember people introducing me as a serious risk taker. I could see why. I had no experience managing a company, nor had I ever been out of academia. But I never thought of myself as such. To manage uncertainty, I only ever hired a new employee if we had six months of cash in the bank to cover expenses post hiring.

That is risk thinking, though I never expressed it as such. I could have put that money to use elsewhere – either reinvesting it in new equipment for the company or taking on more than one employee. That could have made us more profit in the long run. But it could also have sunk us if, say, a global pandemic struck and all our revenue evaporated. How would we have paid our employees? But the nest egg bought us time to pivot if we discovered we were on the wrong track or if some radical uncertainty were to strike. What I realized at the time was that there is a clear difference between risk taking and managing the risk you take.

At a fundamental level, managing risk is about having enough liquidity – cash on hand, essentially, or a readily accessible store of wealth that you can easily and cheaply convert into cash. This enables you to hedge bets on things that haven’t yet been anticipated. Houses, vintage sports cars, and collections of fine wines, for example, are about the least liquid assets you can get, whereas holding large cash reserves in a global bank is highly liquid.

Finding yourself illiquid is a huge problem if someone calls you on your debts. You can hold astonishing wealth, but if you are unable to use it to meet your obligations then you can go bankrupt in an instant. While this is easy to keep track of on an individual scale simply by holding some reserves in the bank, illiquidity can creep up on larger corporations and financial institutions as they package up and deploy their assets in various locations, leaving them blind to the bets they are taking with their money. And it is a pitfall into which companies of any size and persons of any value can fall.

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