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An example of hidden sources of fragility in the context of the Mexican Tequila Crisis. Key learning: “there is often an unknown vulnerability that only comes to light when a crisis erupts”

From Bamboo Innovator:

Tequila crisis: The dangers that only come to light in a disaster
Mexico’s “tequila crisis” is the quintessential example of the dangers of original sin. It also holds some cautionary lessons for those who believe the floating exchange rates and foreign borrowing abstinence of emerging markets will now inoculate countries from crises.
Money gushed into Mexico in the early 1990s but when Alan Greenspan, the Federal Reserve chairman, raised interest rates in 1994 the boom came to an abrupt end – and the dollar put pressure on the peso’s peg. By December the government tried to depreciate the peso but the currency crashed by more than 50 per cent.
The government was then brought low by its Tesebonos – peso bonds indexed to the dollar to reassure investors worried about a devaluation. When the peso collapsed the state was unable to pay the Tesebonos and had to be rescued by the US and the International Monetary Fund.
Today Mexico’s finances are transformed. About 80 per cent of its debts are in pesos, the currency floats and the central bank’s reserves are close to $180bn. Original sin is almost eliminated and the country is a firm investor favourite.
But the tequila crisis holds another vital lesson for policy makers and investors that draw comfort from the striking reduction in original sin: that there is often an unknown vulnerability that only comes to light when a crisis erupts.
Mexico’s crash in 1994 was exacerbated by the fact that the recently privatised local banks had themselves quietly accumulated huge exposures to Tesebonos. The currency devaluation therefore hammered the entire domestic banking sector instead of just hurting US banks, causing a ripple throughout Latin America.
Nor did Mexico look particularly vulnerable before the crisis struck. Although the current account deficit was wide and inflation elevated, the budget was not in terrible shape and growth was the fastest in four years in 1994. “Mexico was the poster child of Latin America,” says Prof Calvo. “But when liquidity bubbles burst it reveals weaknesses we cannot see now.”

If you were thinking of applying for the job, this is what Buffett is looking for!

Picking the right person(s) will not be an easy task. It’s not hard, of course, to find smart people, among them individuals who have impressive investment records. But there is far more to successful long-term investing than brains and performance that has recently been good. Over time, markets will do extraordinary, even bizarre, things. A single, big mistake could wipe out a long string of successes. We therefore need someone genetically programmed to recognize and avoid serious risks, including those never before encountered. Certain perils that lurk in investment strategies cannot be spotted by use of the models commonly employed today by financial institutions.

Temperament is also important. Independent thinking, emotional stability, and a keen understanding of both human and institutional behavior is vital to long-term investment success. I’ve seen a lot of very smart people who have lacked these virtues.

From Charlie Munger: “You’ve got to have models in your head. And you’ve got to array your experience—both vicarious and direct—on this latticework of models. You may have noticed students who just try to remember and pound back what is remembered. Well, they fail in school and in life. You’ve got to hang experience on a latticework of models in your head.

I had an early and extreme multidisciplinary cast of mind. I couldn’t stand reaching for a small idea in my own discipline when there was a big idea right over the fence in somebody else’s discipline. So I just grabbed in all directions for the big ideas that would really work.”

That is solid advice and provides a good framework for one’s personal education.

Accepting that we cannot predict the future – i.e., that there will always be unexpected and highly consequential events – is the first step in becoming less fragile and more adaptable. People should be highly skeptical of anyone’s, including their own, ability to predict the future, and instead pursue strategies that can survive whatever may occur. Taleb advises us to be “antifragile”– i.e., to embrace those elements that benefit from volatility, variability, stress, and disorder. This is exactly what we strive to do at Baupost, and Taleb has coined a name for it. The world will always deliver surprises coming from left field, things that have never happened before or, at least, that no one can remember having happened. As Nobel Laureate Daniel Kahneman notes, people tend to underestimate the odds of extreme events that haven’t occurred recently. It’s a tendency known as availability bias. This tendency is crucial to effectively position ourselves to survive and even thrive regardless of an uncertain future. How do we do that? By eschewing portfolio leverage, keeping ample cash balances ready for rapid deployment, pursuing a mostly generalist and flexible approach while avoiding narrow silos, seeking bargain-priced investments where possible adverse developments are already priced in, holding numerous investments with uncorrelated catalysts to drive outcomes irrespective of market levels, maintaining prudent diversification, demanding high intellectual honesty while consistently striving to improve, and having clients whose long-term orientation matches our own.

In the financial markets, there is rarely anything new under the sun, but you can never say you’ve seen it all, and what you thought you would never see can clobber you.

We make no heroic assumptions in our analysis, hoping, instead, that by compounding multiple conservative assumptions, we will create such a substantial margin-of-safety that a lot can go wrong without impairing our capital much or even at all. We never invest just to invest and don’t bet blindly on mean reversion or on historical relationships holding up. Our settings are permanently turned to “risk-off”.

Warren Buffett: “The snowball just happens if you’re in the right kind of snow, and that’s what happened with me. I don’t just mean compounding money either. It’s in terms of understanding the world and what kind of friends you accumulate. You get to select over time, and you’ve got to be your own wet snow, in effect. You’d better be picking up snow as you go along, because you’re not going to be getting back up to the top of the hill again. That’s the way life works.“

Investing requires us to think of the future. But stock markets are a complex adaptive system. This combined with our limited understanding of current and past events makes predicting the future not just hard but plain impossible most times. Thus it is important to understand the limits and limitations of forecasts. But successful investing does not always depend on accurate forecasting particularly when there is an asymmetric return potential versus the capital at risk. This leads to an investment strategy that aims to be anti-fragile – it can survive and do well no matter which future outcome unfolds. It is also important to understand the sources of fragility as we attempt to eliminate them. This is a journal to record my search for asymmetry and anti-fragility through my investment experience.