HOW WE THINK ABOUT RISK, RESERVES, AND CAPITAL PRESERVATION

In Writing & Letters | Written by Daniel Scrivner

Over the years, we’ve been profoundly influenced by the ideas of Tony Deden, Founder and Chairman of the long-term investment holding company Edelweiss Holdings. Tony is a rigorous and original thinker who looks at investing through the lens of the entrepreneur which he describes as “the doer with his own capital, not just the talker and player with that of others.”

The entrepreneur lives in the same world of uncertainty, risk, and competition as the investor, but because the entrepreneur has skin in the game and cares most about the long-term survival of their business, they have a very different set of values which lead to a very different set of conclusions.

In Tony Deden’s wonderful “In defence of having reserves and hoarding gold,” he lays out a framework for thinking about risk and uncertainty, the role of capital reserves, and why Edelweiss Holdings chooses to hold their reserves in gold over fiat currency. We’ve chosen to follow a very similar approach.

Below we share the ideas in this essay that resonate with us and form the basis for how we think about risk, reserves, and capital preservation.

Risk & Uncertainty

One definitive feature of life is that it’s full of ever-present risk and uncertainty. Life is full of chaos, noise, randomness, and fat-tailed outcomes.

Very simply, risk, that is, the fear that something goes wrong, can be simply avoided, embraced as an opportunity, or insured against. Uncertainty, on the other hand, is a permanent part of life. We are surrounded by inescapable uncertainty.

Risk is the fear, and the very real probability, that something will go wrong. While uncertainty is the inescapable reality that risk, in the grandest of senses, are hardly neat or quantifiable.

Unlike financial professionals, who have been trained to think that risks are neat and tidy. That they can be quantified, hedged, and offset. That the goal is to put every last dollar to work to maximize returns. Entrepreneurs see risk more clearly: as the existential threat it can be. And they act accordingly.

In seeking to deploy our savings, we are not really different from the world of an entrepreneur—the doer with his own capital, as opposed to the talker and player with that of others.

Entrepreneurs see risk three-dimensionally, in a much more real and nuanced way that most of us, in part because they understand that there are too many risks to mitigate. Consider this example of a baker as Guido Hülsmann illustrates him in The Myth of the Risk Premium:

Our would-be entrepreneur knows that the revenue of the bakery depends on a multitude of concrete causes, such as the number of other bakeries within walking distance, the number of families with children, the revenue of these families, the effort he puts into merchandising his croissants and breads, the unit prices at which he sells, etc. But he does not know exactly the relative impact of each of these factors on his income.

That is, he does not know how much the customers will value a nice presentation and how much their decisions will depend on price. He might have some rough idea about the relative importance of each of these factors in the past. But he cannot extrapolate this knowledge into the future. He needs speculate or, in Mises’ words, he needs to bet on their relative influence in the future.

Source: Jörg Guido Hülsmann, “The Myth of the Risk Premium” in The Economic Theory of Costs: Foundations and New Directions, ed. M. McCaffrey (London: Routledge, 2018), 133-146.

Entrepreneurs have to speculate, or bet in Mises’ words, about the changes to make in their business to retain their customers and grow revenue over time. They constantly play both offense and defense out of necessity. Because you need both to win.

In the face of such inescapable uncertainty we can never be certain about the ultimate results of our actions. Future conditions may be and will be different from the present ones. So, an entrepreneur uses his skills and judgement to determine the factors which may influence his business, positively or negatively. Then he acts in the present in such a way as to eliminate as far as possible the influence of factors likely to have a negative impact on his business, while increasing the influence of those factors likely to have a positive one. The job of an owner of money capital, such as an investor, is not at all dissimilar.

All of which is why having the resources to invest when investing makes sense, or simply to endure and persevere when times are tough, is so important.

Whenever uncertainty manifests itself in negative ways, we know that our chances to cope with it are higher when we have resources to manoeuvre.

Capital Preservation

Above all else, our primary goal is capital preservation — preventing the permanent impairment of our capital due to mistakes and errors. We have to avoid the mirages of temporary, transient, and fragile opportunities; focusing instead on those that deliver durable value over long periods of time.

The preservation of wealth, just like the operation of our bakery, is an entrepreneurial activity requiring one to distinguish those options of investment that are economically sound from those which are temporary, transient, fragile and baseless.

This may mean focusing on a narrow, profitable niche and eschewing tangential opportunities. It may mean investing more into a current location that’s proven over opening up a new location in an unproven area.

This simplest way to preserve capital is to ensure we have enough capital in reserves to weather any storm, maximize our optionality, and operate from a position of strength. Once you’ve done this, you’ll be able to go on offense when others are focused on defense and survival.

Much like our baker, the first step toward growing the value of our business is ensuring it’s survival. First by building up capital reserves and then by deploying those reserves extremely strategically and opportunistically.

Even under the conditions of routine life uncertainty, holding a portion of one’s capital in reserves is essential.

Let us return to the example of the baker as an illustration. If the baker is interested in the long-term survival of his business and he is successful, he will accumulate savings over time. These savings are his reserves. He does so partly to prepare for uncertainties and unexpected future events. But he may also want to use them to expand his business in the future.

He is not sure yet, but he is considering his options and looking for opportunities. He may want to buy better equipment, expand his product line or even open a new store. He is not sure yet what the best option is, or even if he has considered all the options. But he is preparing for it all.

He knows that, whatever the case, if he wants his business to survive and thrive, he will need reserves. These shield him through difficult times as well as give him the means, when the time is right, to increase the value of his business, its capacity, efficiency, sales and so forth. Having reserves provides him greater independence and hence a greater propensity to survive no matter what the future may hold. By giving him the means to act, reserves reduce his uncertainty.

In the case of our investor entrepreneur, his long-term savings may be in the form of equity participations that have real and lasting economic value. Yet, as is with our baker, he does not have all the information and there is natural uncertainty in what he ought to do.

He keeps his eyes open, but he never knows when an opportunity, such as he sees it, will present itself. What he looks for is rare and difficult to find. Therefore, he keeps his options open by having sufficient reserves to allow him to act when the time does come. As owners of permanent savings, having reserves increases our independence and gives us the means to act upon opportunities as they arise.

Holding Reserves

But what kind of reserves should one hold? And what are the qualities that make an asset suitable to be held as reserves?

Typically, investment companies hold reserves in money or some other money substitute such as government bonds. Our own practice is very different. We have cash in the bank merely so as to meet very short-term obligations. Most of our capital reserves are held in gold. In addition to being very liquid, only physical gold, in our view, possesses all three of these criteria we consider essential characteristics in a reserve asset: scarcity, permanence and independence.

While not appropriate for everyone, the best store of values possess scarcity, permanence, and independence. For Tony Deden and Edelweiss Holdings, only gold possesses all of these qualities. Because only gold is a medium of exchange that’s an asset and not a liability — like cash sitting in a bank account when the bank possess only fractional reserves and lends out the vast majority of assets to earn additional yield. Cash in the bank is a liability on the bank’s balance sheet and in the worst of times it’s treated as such.

Gold is a globally traded, liquid commodity. If our goal is to maximize optionality while ensuring capital preservation what we really need is liquidity.

If the aim of reserves is optionality, then what one needs is not money, but liquidity.

The real goal of holding reserves is to provide safety and liquidity. Not to earn yield.

Despite the fact that reserves in gold give us the ultimate independence from the misfortunes of the present financial system and the liquidity to deploy when opportunities present themselves, gold in itself is not an investment. We do not own it so as to earn money.

To be comfortable holding gold, we must also focus on the durable value of the asset we own and not it’s daily price fluctuations.

The money value of our reserves may go up or down in the short term, but we don’t count this as a risk. On the contrary, we see such reserves, in the present time, as a wise and necessary component to holding something scarce, permanent and independent in a world where both natural and man-made uncertainty dominates and overwhelms all economic calculation.

Because we live in the world of the owner and entrepreneur, our capital reserves are an existential thing. They ensure our ability to survive and thrive long-term, which is the true enabler of smart compounding over time.

Paraphrasing the inimitable Nassim Nicholas Taleb, being an owner of savings is an existential, not just a financial thing.

Survival is always the first prerequisite. So first mitigate the existential threat of not surviving by building up your reserves. Only then have you earned the right to go on offense, strategically and opportunistically, from a position of strength.

In Closing

A few simple rules of thumb on having reserves, mitigating risks, and operating from a position of strength:

Recognize that there are too many risks to mitigate and that you always have to speculate, in Mises’ words, on the relative importance of all the risks and opportunities you see.
Above all else, our primary goal is capital preservation. We define that as preventing the permanent impairment of our capital due to mistakes and errors.
Avoid the mirages of temporary, transient, and fragile opportunities; focusing instead on those that deliver durable value over long periods of time.
To reduce uncertainty, shield yourself in difficult times, and give yourself the means to increase the value of your business, you must first build and keep a reserve of capital.
Having reserves provides us with greater independence, hence a greater propensity to survive no matter what the future may hold. They also give us the means to act on opportunities.
There's nothing more important than liquidity when it comes to capital reserves. Understanding what is truly liquid and what isn't might lead you to hold your reserves in gold over fiat.