Somebody Somewhere Is Doing Something Stupid

April 5, 2019

 

I started my career in global macro investing in 2008. As you can imagine, it was a complete baptism of fire. Storied institutions like Lehman Brothers, Fannie Mae and Freddie Mac were failing every day, with many others coming close to the brink. The next few years hardly afforded investors any respite with crises in Greece and the European periphery threatening to take down large banks and economies. Like many investors, I struggled with how to spot the next crisis that might decimate my investments or provide me with the next opportunity.

 

With time, I've become much more humble about my ability to predict the next conflagration. Some events, such as China's stock market and currency woes in late 2015, seemed poised to become The Next Big One, but eventually passed. Other smaller incidents, such as the Swiss franc revaluation, were not systemic issues, but still proved to be the death knell for exposed hedge funds. 

 

This is hardly new stuff. I've been revisiting the 1997-98 financial crisis which surged through emerging markets and threatened to infect developed markets, knee-capping glitzy investment firms such as the inaptly named Long-Term Capital Management. To quote Paul Blustein, who wrote my favourite book on the subject, it was a series of "crises with bewildering origins and no obvious solutions". The episode reads like a litany of bad economic and financial policy: central banks with reserves considerably lower than thought, banking sectors stuffed with bad loans to risky real estate, overvalued exchange rates, and highly leveraged corporates borrowing in foreign currencies. Through channels like the Japanese banking sector, heavily exposed to emerging Asia, and hedge funds like LTCM, these issues could have ignited major crises in developed markets as well.

 

But it would be a mistake to believe that these problems were visible in real time. As Warren Buffett brilliantly noted, it's only when the tide goes out that you see who's been swimming naked. Post-2008, I desperately wanted to believe that if I just paid more attention to developing problems, I could get ahead of them. But I no longer believe that's necessarily possible.

 

Instead, I think we have to operate on a simple principle: somebody somewhere is doing something stupid. Sometimes those things are more visible; sometimes they're hidden in dark corners of the financial world. Sometimes they're relatively isolated, and sometimes they can sweep through markets like a wildfire. It's really, really hard to know which is which. 

 

The response to this, I think, is to build systems to defend yourself from other people's foolishness (and to be humble about your own portfolio). For some, this may take the form of short bets or more sophisticated portfolio insurance (itself a tricky concept). For others, it may simply mean investing in high quality assets, eschewing leverage (often the greatest source of fragility) or holding cash as a buffer. While inefficient, it ensures your survival to fight another day. The only way to build a great long-term track record, after all, is to be around for the long term.

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