3 Lessons from When Genius Failed By Roger Lowenstein

How to NOT lose everything

The Rise of Long-Term Capital Management

In 1993, LTCM was formed by three academics: John Meriwether, Robert C. Merton, and Myron Scholes. This combination, along with some well-known traders, is the financial equivalent of 1970s Boston Celtics. It was the all-star team of the financial markets. They were the smartest and best in the world... And they knew it.

The fund quickly racked up some impressive wins with very little volatility. Over the first four years they returned an astounding 30 percent per year. These wins drew a lot of investor attention and a lot of investor capital.

It soon became one of the largest hedge funds in history. Many wealthy investors clamored to get into the fund. But they had a waiting list. By the end, they raised $5 billion at their peak, which I'm told was 2.5 times larger than Fidelity's Magellan Fund - the largest mutual fund at the time.

A Hedge Fund With Too Much Hubris

All this success went straight to the heads of those in charge of LTCM. And this is a lesson that all barbell investors can heed closely.

Remember, we try to keep 80% of our assets in safe investments that won't go down in value... Even if the market crashes. This requires us to keep a close eye on our risk management of the majority of our portfolio.

And no matter how good our strategy is we need to be aware that an unexpected crisis, such as the Asian crisis in 1998, could cause vicious market swings that lead to losses.

The people behind LTCM were the smartest in the world... Likely smarter than all of us (a humbling thought!) and even their models broke.

Even mathematical models that were supposedly safe. Remember, no matter how good a strategy has been the future price of securities are unknowable. Use the lessons learned in this book to remember to remain humble. And never overextend your portfolio.

Here are the three lessons we can take away.

All Investable Edges Eventually Get Competed Away

Meriwether & Co. set up their investment fund to take advantage of spreads and arbitrage opportunities in the world markets.

Arbitrage is the process of purchasing one asset and immediately reselling it at a higher price. For example, you might buy an ounce of gold in the U.S. for $1,700. And then immediately sell an ounce in Asia for $1,710. If you do this over and over again, you make money every single time. In fact, there are many different types of arbitrage trades, including currency swaps, options, futures contracts, and interest rates.

Long-term capital management (LTCM) was a hedge fund that specialized in making money via arbitrage. Or so they said. They exploited spreads in the foreign bond and currency markets. When the markets got out of whack, they would enter a position and then close out once the market returned to normal.

But LTCM's visible profile caught the attention of a lot of investors. There were copycats and then there were those who took positions against the fund when they spotted weakness. Eventually the markets broke. It was a "fat tail," black swan event. An event that is never supposed to happen.

And when the Asian Financial Crisis swept the globe. South Korea and Taiwan saw their currencies decimated. And the Russian default on their bonds rattled the markets in ways we hadn't seen in decades.

LTCM was caught with their pants down. And the problems were magnified by their biggest sin... Or next lesson.

And that strategy works as long as the markets are normal. But eventually

LTCM Utilized Crazy Amounts of Leverage

They had complex academic models showing they were properly hedged and the risk was contained. The belief in this allowed them to borrow billions more dollars... And buy derivative securities with a notional values in the trillions of dollars.

The problem with LTCM was that they took on too much risk. This was their fatal flaw. One of their main strategies involved betting on a rise in interest rates, which meant that they needed to borrow money cheaply. This allowed them to invest even larger amounts of capital. But there was one small problem: no bank would loan them money because they didn't want to lose money themselves. So they borrowed from each other, creating a giant pyramid scheme.

Experts say LTCM's leverage ratio peaked 28 to 1... Which is crazy. But when we factor in these derivatives, that ratio was much higher.

When the markets turned, LTCM had a lack of capital to close their positions. And they needed to be bailed out by investment banks and the U.S. government.

LTCM's Last Weeks were Plagued by "Impossible" Events

LTCM’s model's didn't predict the collapse of the Russian bond market. But it happened.

They were overly confident in their expert knowledge and complex models. But models are meant to be broken. We're not going to talk about crazy events that could happen in the future right now. They are by definition unknowable. If we knew something bad would happen, we would prepare for it ahead of time. There would be no surprises.

Black swan events happen all the time... they seem to happen more and more in recent decades as the financial system becomes more intertwined.

I'm sure we will see many more of these events... Likely every couple years. So buckle up.

Don't get to cocky in your models or trading plans. They may work with amazing success now. But remain humble. Don't try to leverage up and hit a homerun... You may get lucky, but odds are eventually, you'll blow up like the LTCM guys.

Or if you see a trading strategy that touts a 99% success rate be careful. These strategies usually involve picking up small 2% returns. And it works great. But when they markets turn, you can lose everything if you leverage up.

Mind your risk.

That's the most important lesson for barbell investors to remember here.

When Genius Failed is a great book to read as a reminder to remain humble. Click here to purchase this book.

A dollar saved is worth more than a dollar earned.