At Yoursurvivalguy.com, I regularly warn you away from the novel, the trendy, and the unproven strategies that keep the Wall Street fee-machine cranking. I want you to survive the investing gauntlet, not to be chewed up by schemers or inept profiteers looking to take your money.
Risky hedge funds, cryptocurrencies, and unsavory pension fund strategies are all traps I have encouraged you to avoid. If you’ve been investing over the last decade you have surely heard of Bernie Madoff and his scheme to defraud investors. But if you have been investing for a bit longer like me, you’ll remember a hedge fund that nearly took down the global financial system, not with nefarious intent, but by overestimating the skill level of its strategists.
The event I’m referring to is the Long-Term Capital Management crisis, in which Nobel prize winning economists and other financial elites thought they had cracked the code to unlimited profits. What had really happened was something that has happened to many unfortunate investors time and again through history; they took on risks they didn’t understand and got burned when reality caught up to their game. The difference with LTCM though, was that they had invested so much and on such a global scale, that their failure disrupted the entire global financial system.
One of the better synopses of what happened to LTCM was written by Roger Lowenstein, author of When Genius Failed: The Rise and Fall of Long-Term Capital Management. Lowenstein wrote in the midst of the 2008 financial crisis that the world learned nothing from the LTCM debacle, and was repeating the same mistakes. In The New York Times in September 2008, Lowenstein wrote:
Modern finance is an antiseptic discipline; it eschews anecdotes and examples, which are messy and possibly misleading — but nonetheless real. It favors abstraction, which is perfect but theoretical. Rather than evaluate financial assets case by case, financial models rely on the notion of randomness, which has huge implications for diversification. It means two investments are safer than one, three safer than two.
The theory of option pricing, the Black-Scholes formula, is the cornerstone of modern finance and was devised by two Long-Term Capital partners, Robert Merton and Myron Scholes, along with one other scholar. It is based on the idea that each new price is random, like a coin flip.
Long-Term Capital’s partners were shocked that their trades, spanning multiple asset classes, crashed in unison. But markets aren’t so random. In times of stress, the correlations rise. People in a panic sell stocks — all stocks. Lenders who are under pressure tighten credit to all.
And Long-Term Capital’s investments were far more correlated than it realized. In different markets, it made essentially the same bet: that risk premiums — the amount lenders charge for riskier assets — would fall. Was it so surprising that when Russia defaulted, risk premiums everywhere rose?
More recently, housing lenders — and the rating agencies who put triple-A seals on mortgage securities — similarly misjudged the correlations. The housing market of California was said to be distinct from Florida’s; Arizona’s was not like Michigan’s. And though one subprime holder might default, the odds that three or six would default were exponentially less. Randomness ensured (or so it was believed) a diverse performance; diversity guaranteed safety.
After Long-Term Capital’s fall, many commentators blamed a lack of liquidity. They said panic selling in thin markets pushed its assets below their economic value. That’s why leverage is dangerous; if you operate with borrowed money, you lack the luxury of waiting until prices correct.
The fund’s partners likened their disaster to a “100-year flood”— a freak event like Katrina or the Chicago Cubs baseball team winning the World Series. (The Cubs last won in 1908; right on schedule, they are in contention to repeat.) But their strategies would have lost big money this year, too.
John Meriwether, the fund’s founder, later organized a new fund, which suffered big losses early this year, according to press reports.
If 100-year floods visit markets every decade or so, it is because our knowledge of the cards in history’s deck keeps expanding. When perceptions change, liquidity evaporates quickly. Indeed, the belief that one can safely get out of a “liquid” market is one of the great fallacies of investing.
This lesson went unlearned.
Don’t miss the lessons of history. Focus on the risk in your portfolio for your own survival. Read more from Lowenstein here.
E.J. Smith - Your Survival Guy
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