„When genius failed“ - Roger Lowenstein (2001)
Roger Lowenstein talks about the rise and fall of “long term capital management” in „When genius failed“. It’s about a hedge-fund that made huge profits over the years until it went down crashing big time in 1998.
Just imagine: a visionary trader at Salomon Brothers and future vice-president of the company, who knows how to forge teams and add a group of university math professors and financial experts to it (including two later noble price winners).
Doesn’t that sound like pure cash in your ears?
Wouldn’t you bet, that such a team could invent a system that would make a lot of money?
I’m sure you do!
So would I and so did most of the big wall-street Investment Banks, well let´s say most of the big banks around the world.
This decision didn’t look like a failure for a few years.
Long-term capital started in 1994 and began making a lot of money - it seemed nearly impossible that this streak could end in the near future.
But it did - very rapidly, as well. In 1998 the whole card house crashed and ripped a billion Dollar hole.
The main point giving us a lecture is not that the genius-team failed, but how the fund crashed. It is a grand example about risk and human psychology. And the discovery, that even the smartest are not shielded against psychological traps.
It’s part of the human nature, that you, while in a winning streak, totally neglect the thought of losing. Well - why should you be thinking about losing, when everything is working out great – right?
And that’s the big mistake people make when figuring out how to deal with the risk in trading.
It is even worse, when you’ve never lost before - like the LTCM team.
Those are the most vulnerable ones.
The team at Long Term Capital Management took lots of risks with all that money they had, and they were pretty successful. So they took more risk not really thinking about the consequences or the possibilities of a crash. In that erspective they they didn’t have a working risk-management, because they didn´t realize that they became the market!
Why talking about losses, when there are none?
But that’s the point. You have to think about your losses, even before you take any risk.
„When genius failed“ can teach you a lot about taking risk.
And learning from the mistakes that others make is a good way to prevent you from doing the same in the future.