The man’s trouble was that he was not able to imagine. As he looked back at the trail, which revealed to him nothing but grey clouds and a white earth, he felt nothing. No worry. It was cold and uncomfortable. Nothing more than that. He failed to consider the gravity of the situation he was in. He failed to consider that man can only exist within a thin boundary of hot and cold. He failed to consider that even a brief exposure to the cold, either by accident or intentionally, would cause considerable discomfort at best, and death at worst. In the words of Jacob Geller, a monster might kill you, but the cold will.
Long Term Capital Management (LTCM from now on) was a hedge fund that was created by the best of the best. Among its partners were two Nobel Prize winners in Economics, and the pioneers in a field called options trading, a field the firm was highly involved in. Others included the group of people who had set up and grown the bond arbitrage branch at Salomon Brothers. As such, what they had, more than anything else, was credibility. These were the smartest people on wallstreet. And they were starting a hedge fund. People wanted in, and the firm raised somewhere in the region of $1 billion - this without the investors seeing what the fund was going to do with their money. The fund was set up in 1994. It had three extremely good years where it basically quadrupled it’s investor’s money, a return that is almost mythical. And then, in it’s fourth year, it collapsed, and had to be bailed out.
Be Careful With Debt My Friends
Leverage - or debt - is a tool that can create miracles. Leverage can quite simply create something out of nothing. There are countless stories of big businesses that became what they were through debt. They borrowed some cash, either from family, friends or financial institutions, and started a business that went on to create considerable wealth for its owners. In this case, they started with nothing, and ended up rich. There’s a great number of families that have a home because of mortgage. A car. Debt can be super awesome for the people who understand it and know how to use it. But just as debt gives, so it takes.
LTCM was leveraged 30-1. This means that for every $100 the company invested, only about $3 was the investor’s money. The rest was borrowed from the banks. And the banks had incentive to do so. This was a big hedge fund, with big money, and wonderful returns. LTCM was good business for them. This level of leverage magnifies returns to the same tune. A 1% gain in the fund’s investments would mean an almost 33% gain in terms of the actual capital in the fund - the investor’s money. This might help to explain how the fund made the kind of returns it made in the first three years. And that’s the beauty of leverage. It magnifies results. The more of it you have, the higher the returns you can get. Provided the line goes up. If the line goes down, well, you’re fucked.
Let’s imagine what a 1% loss in the investments would mean. Your investments are worth $99 now, but you still have to pay $100. The extra dollar comes from the $3 in actual cash you have, leaving you with $2. That’s a 30% drop in your actual capital. And that’s the flip side of leverage. It magnifies returns on both sides. And given this example, the investments only need to go down by 3% or more for you to get wiped out. That’s what happened with LTCM. When the Asian financial crisis and the Russian defaults in the 1997-1998 occurred, it created a big enough shock for the company to get wiped out.
Remember, Only God Knows The Future
Assume a gambler has to bet on a coin toss. A coin that is, in the words of Thanos, perfectly balanced. There’s a 50% chance of heads or tails. Assume the first five tosses all come up as heads. The gambler - and the general population, if we’re honest - assumes that there’s a very high likelihood that the next toss comes up as tails. But here’s the thing, the odds are still the same - 50-50. The coin has no memory of the previous results. So while the gambler thinks betting on tails gives him/her a higher chance of winning, the chances remain the same. The same can be said of a gambler who keeps winning. The assumption is that they will keep winning. But the past is never an exact predictor of the future.
I mentioned above that the firm had two Nobel Laureates in their ranks. Well, those two developed the models that the firm used to decide and measure their trades. These models tried to measure risk based on past data and a few assumptions, key among them the theory of efficient markets. But a few problems arise from this. First, past events predict the future roughly, not precisely. Nothing ever happens exactly as it did in the past. And adding to that, to get a good prediction of the future, even a rough one, you need representative data. LTCM used five years worth of data to develop their models. Five years of data in a sector that had existed for at least a hundred years. It didn’t even go as far as 1987, which would have helped the data account for market shocks. It was five years of the best data available. Not even close to representative. As a result, the risk that the firm accounted for was too low. And the shocks of 1997-1998 blew way past them easily.
A Person Is Smart. People Are Stupid.
There’s a reason that Economics is not considered a hard science, no matter how much we the practitioners try to make it one. That’s because central to all economic theory is the assumption - assumption being the key word - of rationality. We develop theories based on the assumption that people will act in a rational manner. But human behavior is very rarely rational, at least in the short term. People do the most irrational things in the short term, sometimes to their own detriment. Let’s not forget people rushing to buy tissue paper, of all things, when the lockdowns started. And most economic theory falls apart because of this assumption rarely holds. If you are to take a lesson from this, it’s that humans occupy two extremes - over-enthusiasm and under-enthusiasm.
LTCM’s models were developed based on the assumption that markets are, for the most part, rational. But markets very rarely are. They operate on a relatively predictable pattern of boom and bust cycles. Over-enthusiasm and under-enthusiasm. People overreact to both bad news and good news. In the case of LTCM, the crises of 1997-1998 created a situation where prices started to fall. People holding those assets, in order to minimize losses, started selling a portion of their holdings. But because of this, those prices fell further, and the people holding the assets, again, in order to minimize losses, looked to further divest their holdings. This created a vicious self-repeating cycle that drove the assets down. LTCM, the biggest player in the assets most highly affected - bonds - couldn’t sell. They had the largest exposure. If they did, they’d practically kill the market. And so they held, and looked as the prices went past what their models had incorporated. A lot of the assets were still as sound then as the year before. This wasn’t an issue with the assets themselves. This was just fear.
Everything Goes To Shit during Bad Times.
When we say items are correlated, we mean that they behave in a similar manner, often affecting one another in many ways. Bitcoin was for a long time not correlated to the stock market, often behaving like it had a mind of its own. It’s price shot up several times that of the stock market, creating a FOMO reaction from a lot of people, including me. That was until the Federal Reserve of the US started raising interest rates. And the correlation went to one. All of a sudden, the entire crypto market was moving in sync with the stock market. In a shit market, everyone is selling. No one is safe.
LTCM, at the start, was mostly dealing in bond arbitrage, the specialty of its founders. However, after some time, they went into options trading. They also entered into positions in foreign markets. All these markets were, for the most part, moving independently from each other. As such, this provided the unicorn of investing that is diversification. A bad day in one market would easily be covered by the other markets. But then the events of 1997/1998 happened, creating a shock strong enough to cause people to go into a frenzy. Selling pressure came from all fronts. First in the riskier investments such as the Russian bonds. But then this selling pressure hit the more secure bonds. And it soon spread to the stock markets. In Asia. In South America. In the US. Everything LTCM touched was selling off. They had missed an important rule. Markets are not correlated. But this only holds in good times. In bad times, correlations often go to one.