The price of intelligence: the Nobel Prize winner's defeat
2024-08-08
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(The author of this article is Zhang Xiaoquan, Irwin and Joan Jacobs Professor of School of Economics and Management, Tsinghua University)
As an investor, you are bound to be accompanied by volatility, risk and uncertainty throughout your investment career. However, these factors are often hated or feared by most people.
This is exactly the anti-human point in investing.
The more you fear and hate volatility, risk and uncertainty, the more likely you are to be punished by them, while smart investors will choose to face them, understand them, and then use them to get rewarded in the end.
In previous articles, we have talked about risk and uncertainty many times. So, here is a small test to test your understanding of these concepts.
The curve in the picture below shows real data of four assets. If you were asked to invest in one of these assets, which one would you choose?
Did you choose the right one? Of course, this is just a test, and there is no substantial loss even if you choose the black line.
But the reality is real and tragic. Countless people have invested in black assets. They are the victims of the largest Ponzi scheme in American history, with a total loss of about 65 billion (this story is also very interesting, and I may write a separate article later).
The picture below is also a real-life asset trend chart, and you can make another choice.
The blue curve is the protagonist we will talk about next - Long-Term Capital Management (LTCM), which was once a famous darling of Wall Street and a hedge fund with a top management team and outstanding performance.
LTCM has nothing to do with the above scam funds. They are put together only because of their similar trends. More importantly, they both reflect the harm that a misunderstanding of volatility, risk and uncertainty can bring to investors.
When Genius Fails
"I have seen the best minds of my generation destroyed by madness..." - Allen Ginsberg (author)
Ironically, the life cycle of Long-Term Capital Management was not long, only four years (1994-1998). But from another perspective, the impact of the closure of LTCM was indeed long-lasting and far-reaching.
The fall of LTCM is like the Titanic of the financial world; its rise and fall have all the hallmarks of a legendary story.
Dream start:A genius mind, dazzling success, and great wealth;
Unexpected changes:Sudden major crises, devastating blows, and incalculable collateral risks;
Sad ending:A rescue at a critical moment and a thought-provoking ending.
There are too many articles and books that have analyzed and introduced the rise and fall of LTCM in detail. One of them is an international bestseller called "When Genius Failed: The Rise and Fall of Long-Term Capital Management". The main title of the Chinese translation "The Gambler: The Rise and Fall of Long-Term Capital Management" is even more poignant and straightforward.
In the book, author Roger Lowenstein injects the basic elements of classical tragedy into LTCM: hubris ruins glory.
The reader will come away with a simple but enduring conclusion: beware of overconfidence.
The second lesson has to do with leverage. As Carol Loomis, a longtime editor of Fortune magazine and Buffett’s shareholder letters, put it: “At LTCM, the best talent was destroyed by finance’s oldest and most famous addiction.”
Although every crisis and disaster in financial history is different, the core of the story is surprisingly similar. The history of Wall Street always repeats itself, and all old news becomes news. What LTCM experienced has long been a lesson. Sadly, "the only lesson that mankind can learn from history is that mankind has never learned any lessons from history."
Nevertheless, the story of LTCM is worth knowing. I will skip some details here and only talk about the most important parts. If you are interested in the historical details and the characters involved, you can read the book mentioned above.
Team: All-Star "Dream Team"
When it comes to LTCM, one highlight that cannot be ignored is its management team, which is also an important factor in the success of this fund. It has an ultra-luxurious star lineup and can be called the "dream team" combination of Wall Street finance.
The most prominent ones are naturally two financial academic giants, Nobel Prize winners in economics Robert Merton and Myron Scholes.
Merton and Scholes’ work has become the foundation of modern financial markets. The Black-Scholes Formula (co-creator Fischer Black is deceased and did not share the Nobel Prize) that is used by countless traders and investors around the world every day to determine stock option prices is derived from their contributions, which is enough to illustrate their status in the financial field.
LTCM's founder, John Meriwether, was once the chief trader of the famous investment bank Salomon Brothers. He is said to have contributed more than 80% of the company's profits, and therefore enjoyed a high reputation on Wall Street.
Later, due to a trading scandal involving his subordinates, Meriwether was forced to leave Salomon Brothers and decided to start his own hedge fund, which had to meet the industry's top standards to make money for himself.
Meriwether had a simple strategy: surround yourself with the brightest minds to succeed.
That’s why he assembled an all-star team of traders and academics to bring together the knowledge of various academics (quantitative models) and the skills of traders (market judgment, execution capabilities).
Relying on his personal charm, Meriwether recruited economist, former Federal Reserve Vice Chairman and former U.S. Treasury Deputy Secretary David W. Mullins Jr. into the partnership team.
Subsequently, it recruited former Goldman Sachs vice president Eric Rosenfeld, former Salomon Brothers executives and managing directors Victor Haghani and Greg Hawkins, and others.
At this point, financial executives, Wall Street elites and academic giants have joined forces to form a "dream team" unprecedented in the fund industry.
Perhaps because it was confident in the attractiveness of its team of top talent, LTCM also set very harsh conditions for investors: each investor had to invest at least $10 million, the funds were frozen for three years, investors could not view the transaction status, and had to pay the highest commission at the time.
Even so, by the day LTCM began trading (February 24, 1994), the firm had raised more than $1.01 billion in capital.
With the blessing of the star halo effect and the temptation of huge potential profits, many people regarded investing in LTCM as a golden opportunity and an honor. Many large investment banks, including senior investors such as Bell, Merrill Lynch, and UBS Group, flocked to invest more than $1.3 billion.
Strategy: “Too smart to fail”
“The wonderful task of economics is to demonstrate to men how little they really know about the things they think they can design.” — Friedrich Hayek (Economist)
LTCM's primary investment approach was to identify bond pairs that typically maintained predictable spreads and then leverage the spread, betting that as the spread widened further, the two bond prices would converge. This strategy, often referred to as convergence trading, involves using quantitative models to exploit pricing anomalies in liquid security relationships across countries and asset classes.
It is important to note that all of these models are based on statistics and past experience. In other words, they are modeling the past, and then when trading, the expected future market behavior will be limited to past events and there will be a certain degree of deviation.
LTCM invested in a range of assets and strategies, including:
stable income
a) Arbitrage:Looking for opportunities to profit from price differences, by buying cheap securities and shorting expensive securities, to extract small profits from hedged positions. LTCM's rationale was based on the historical performance of the convergence of interest rate differentials between risky assets and risk-free assets.
b) European market integration:LTCM believed that as European markets integrated, it had to ensure that the 11 member states would eventually need to adjust interest rates.
stock
Given the previous success, LTCM believed the strategy could be transferred to stocks.
As of June 1998, the fund owned stocks in 76 companies valued at $539.2 million.
a) Paired trading between related stocks:LTCM took a $2.3 billion position in Royal Dutch Petroleum and Shell Shipping, with the latter historically trading at an 18% discount to the former. LTCM took advantage of this by going half long Shell and half short Royal Dutch, betting that the spread would narrow.
b) Risk arbitrage:Rather than buying the shares outright, LTCM bet on the merger of Citigroup and Travelers Group by entering into total return swaps with Wall Street firms. These swaps allowed LTCM to use leverage to amplify returns while shifting much of the risk to its trading partners.
c) Market volatility:LTCM made bets when market volatility was unusually high, anticipating that markets would return to historically normal levels.
As of the end of 1997, LTCM had net assets of $7 billion and total assets of $100 billion, twice the size of the largest mutual fund, Fidelity, and four times the size of the industry's second-largest hedge fund.
Meanwhile, LTCM’s debt had ballooned to about $125 billion, with a balance sheet leverage ratio of 25 to 1. This figure did not accurately reflect the fund’s actual credit risk, which was further magnified by its involvement in risky off-balance sheet derivative contracts.
In fact, LTCM's market risk exceeded $1 trillion. But the management team had great confidence in their financial algorithms, because the results they calculated based on historical data showed that the probability of failure was minimal, and the probability of loss could even be accurate to several decimal places.
Everything is under control... until things start to get out of control.
The Black Swan: From Midas Touch to No Return
"If, strictly speaking, all activities in the world were repeated as they were in the past, then all risks would cease to exist." -Merton H. Miller (Economist, Nobel Prize winner)
Someone once said to Scholes, "You can't make so much money in the Treasury bond market." Scholes replied, "It's because of fools like you that we can do it."
Indeed, if the world worked as their model predicted, LTCM could become a money-printing machine. In fact, they did briefly turn everything they touched into gold, as evidenced by their enviable performance.
LTCM achieved a 20% return in the first 10 months of 1994, 43% in 1995, 41% in 1996, and a respectable 17% in 1997. And all this with almost no volatility!
Little do they know that all these seemingly “zero-risk” gifts have already been secretly marked with a price. Could it be that these highly intelligent people are completely unaware of this?
One possible explanation is the “winner effect”.
As earnings continue to soar, stakeholders—partners, banks, and investors—continue to pour money into what seems like a sure thing. Confidence breeds more confidence until it all comes crashing down.
As the saying goes, “Success is due to Xiao He, and failure is also due to Xiao He.” Leverage can make LTCM’s profits soar to the sky, but it can also drag its losses into the abyss.
Russia defaulting on its debt in 1998 was like the butterfly flapping its wings to cause a hurricane. When money began to flee to liquidity, the time bomb had been activated, confidence fled, and the gold rush myth of LTCM gradually collapsed and then ceased to exist.
Later, the Federal Reserve teamed up with major banks to form a consortium to rescue LTCM. This rescue also conveyed the idea of "too big to fail" to the society, which laid the hidden dangers for some accidents in the 2008 financial crisis.
If LTCM’s partners and employees had been greedy gamblers or naive, inexperienced traders, its problems would have been predictable and uninteresting. But they were neither. The top professionals on Wall Street held the partners in high esteem, and in many cases still do.
The problems and lessons are obvious:
1) Without a deep understanding of volatility, risk and uncertainty, they use mathematical calculations to treat uncertainty as a precisely controllable risk probability, and treat extremely low-probability events as impossible to occur, creating the illusion of "zero risk" returns;
2) Excessive leverage, excessive borrowing, and lack of liquidity;
3) Overconfidence and over-reliance on models that rely on a series of unreliable assumptions (historical performance, efficient markets, rational people);
4) Believe that the market is likely to be a random walk with a normal distribution, ignoring the existence of the "fat tail".
“The creation of wealth is not simply a physical process and cannot be explained by a chain of cause and effect alone. It is determined not by objective physical facts known to any one person but by the individually divergent information of millions of people, which precipitates in prices and thus guides further decisions.” — Friedrich Hayek (Economist)
In addition, investors should also consider the following questions:
1) Most people do not understand risk or uncertainty, which is the opportunity for alpha2) Antifragility①There is only one bullet in ten thousand magazines② How to benefit yourself when the worst happens③It’s too late to respond④The difference between wise and smart
The story should end here, but the failure of a genius inevitably makes people wonder: Is there another possibility?
We will discuss this issue in the next article.
This article only reflects the author’s views.
