When Genius Failed: LTCM and the Flawed Assumptions of Modern Finance

 

The story of Long Term Capital Management, a hedge fund that collapsed dramatically in 1998, is instructive to anyone with an interest in modern finance. Roger Lowenstein gives the definitive account of the rise and fall of LTCM in his book ‘When Genius Failed’, now part of the business-lit canon.

When it was founded in 1994 LTCM was notable for the outstanding pedigree of its partners, a mixture of experienced traders and renowned academics, including Myron Scholes and Robert Merton, two professors who helped invent option pricing theory and would later share a Nobel Prize. The premise was simple: they would identify small anomalies in bond prices, then make massively leveraged bets that the anomalies would disappear. Relying on economic theory and past data on market movements they could identify theoretical mis-pricing in the market and profit from the correction in market prices.

The fund initially made terrific returns, peaking in April 1998 with a 300% profit, a sum of over $4bn. Between that point and September 1998, the fund managed to lose a spectacular $4.5bn, reaching the point where its imminent bankruptcy threatened the whole financial system. How did such smart people lose so much money? Leverage and bad luck both played a part. But fundamentally the fund based its trades on the same assumptions that underlie much modern financial theory, assumptions that have repeatedly proved to be untrue. Here are three:

1. Governments debt is ‘risk-free’
   Until recently it was expected that powerful governments would never default on their debt. This belief was eroded by various crises, and in the mid-nineties the conventional wisdom was only that nuclear powers would never default. LTCM expected this to hold and was seriously caught out when Russia stopped paying its creditors in 1998. Nowadays it is accepted that even developed nations may default (they have simply accumulated so much debt), but nevertheless the US Government is still considered a ‘risk-free’ borrower. The concept of the ‘risk-free rate’ indeed lies at the heart of the equations used for investment decisions – so accepting that there is no such thing would require a new ‘relativistic’ framework at the heart of finance. With the US deficit out of control and its politics in paralysis, maybe the invention/adoption of a new framework is overdue.
    
2. Markets are efficient, or tend towards being efficient*
   
   While it is generally accepted that markets stray from being efficient in the short run, many economists still believe that in the long run prices always converge with intrinsic values. Many investors, including LTCM, base their investment decisions on this assumption. In LTCM’s case, it served them well for several years – but backfired massively in 1998 when prices became more volatile than any of the ‘fundamentals’ would suggest they should have. Instead of cutting their losses when markets moved against them, the managers of LTCM were so confident that they increased their positions. The ‘Efficient Long-Run’ is a dangerous myth, and while many academics recognise this (and are working out why prices move irrationally) it is a myth that endures.
3. Your trades do not move the market
   
   Finance theory is based on the perspective of a small investor whose individual actions do not affect market behaviour. One corollary of this is that there will always be a buyer for one’s assets, at the market price. LTCM was a long way from this theoretical ideal. With over $100bn in assets placed on a fairly small number of trades, it was like a whale in a swimming pool: the slightest move could make waves in the markets. It entered into trades so large that it could not exit them without prices in the market dropping. When liquidity in its markets (mostly exotic derivatives) dried up, it was left with no means of ‘cutting its losses’ on losing trades.

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Perhaps astoundingly, these assumptions are still widely believed and still guide much of the financial industry and government policy. The implosion of LTCM should have been a wake-up call, but instead it was patched up and things returned to business-as-usual, sowing the seeds for the 2008-09 financial crisis. Many prominent investors and academics have been openly questioning these assumptions for decades (Soros, Buffett, Stiglitz and Shiller to name a few) but as yet the core of the finance establishment is yet to change. Perhaps the absence of a convincing and functional alternative theory is holding back change? Perhaps, herein lies an opportunity to come up with something new?

*'Market Efficiency' is the idea that prices of assets reflect all available information about the current and future value of the asset and as a result all assets are properly priced (i.e. price = intrinsic value)

What Baseball has to Teach Us About Business Success - a Review of Michael Lewis' Moneyball

I’ve just finished reading Moneyball by Michael Lewis, a writer made famous by his banking classic ‘Liar’s Poker.’ One of the modern classics of sports writing, Moneyball follows the story of a baseball team, the Oakland Athletics, which employed the unorthodox tool of statistics to pick players and win games.

The way Lewis describes it, the vast majority of the baseball industry relies on experience, intuition, and tradition to make these choices. In a sport that generates a vast trove of statistics on players’ and teams’ performances, only a small group of fans, known as ‘sabermetricians,’ used to bother subjecting the data to hard analysis. This changed in the late 1990s when Billy Beane, general manager of the Oakland A’s, realised that to stand a chance against wealthier teams he would have to organise his team differently. Together with Harvard graduate Paul de Podesta he set about analysing baseball to determine, amongst other things, how you can use historic performance statistics to value players (and work out which attributes are underpriced in the market), and which tactics help you win games. On both these questions the conventional wisdom was wrong, and using their analysis Beane and de Podesta put together a successful team on a low budget.

I myself am not a big baseball fan, but I was drawn to the book by references to it in a number of modern business books. The story Lewis tells has some wider messages that resonate far beyond the baseball diamond.

1. When used properly, statistics can be a goldmine

The rest of the industry were not ignoring statistics. They were simply focussing on the wrong ones. They had never subjected the raw data to a statistically valid analysis using the tools of probability, hypothesis testing and regression analysis. This attitude – taking basic statistics such as means, medians and ranges – leads to simplistic conclusions and overlooks the value of deeper analysis. Proper use of statistics can give a business an advantage over its competitors. It can also have great effect in non-competitive sectors such as public services or international development.

2. When a competitor is being unexpectedly successful, don’t dismiss this as an aberration

This is a mistake big businesses make all too often. They assume that a competitor’s success is down to luck, temporary trends, or the unique success of a single initiative or product. While this might be true, a competitor which consistently outperforms is probably doing something substantially better than you. There is no denying that baseball contains a strong element of luck. So when the Oakland A’s had a couple of good seasons, competitors were not too concerned. However even when the A’s continued to outperform year after year, with ‘winning streaks’ of historic length few competitors stopped and questioned how they did it. Even after Moneyball was published, much of the industry remained in denial about the power of statistics.

3. Don’t just accept the conventional wisdom – and don’t be afraid to look for a new way

The conventional wisdom in baseball was that you need to hire star players to make a team better. Billy Beane did not have the budget to hire stars – but he didn’t accept the conventional wisdom either. He looked for another route to success – one his competitors would have overlooked – and he found it. This is a step that many successful businesses, investors and entrepreneurs have taken, ranging from Toyota reinventing the way car production is organised to Apple’s launch of the iPad, a product in an entirely new category overlooked by every other electronics firm in the world.

As a book Moneyball has a great deal to offer sports fans in general and baseball fans in particular. But it also contains lessons that are useful to a wider audience, namely: look to the numbers, and if they conflict with the conventional wisdom, then the conventional wisdom is probably wrong.

Why I'm a fan of 'The Seven Habits'

A few weeks ago I had dinner with an old friend. Having noticed my reviews of several business books, he asked me to recommend my favourite ever book on ‘personal effectiveness.’ I didn’t have to think for long before responding: the book I have found most compelling has been ‘The Seven Habits of Highly Effective People’ by Stephen Covey.

I’m not an expert on the ‘success’ and ‘self-improvement’ literature, but I’m not a cynic either. Several of my friends would never pick up a book of this genre, believing that they’re aimed at people who have low self-esteem, who lack confidence or who otherwise feel that they are in some way flawed. While some proportion of self-improvement books is aimed at this kind of audience, I have found many titles with a lot to offer readers who are already confident and well-adjusted individuals.

‘The Seven Habits’ is one of these. It has several great things going for it:

• Stephen Covey is an expert in what he is writing about. He has a thorough knowledge of the existing success literature which he has studied at length. His depth of knowledge shows through in what he writes.
• Covey acknowledges up front the low quality of much of the self-improvement literature. He has a clear disdain for books that promise a ‘quick fix.’ This honest approach make much of what he recommends that bit more compelling.
• His writing style is very accessible; he illustrates all his points with anecdotes either from his own experiences of those related to him by others. This puts all of his ‘Seven Habits’ into context and prevents the book becoming dry and overly theoretical. He includes some ‘thought exercises’ which engage the reader, but not to the point it reads like an instruction manual.
• The content itself makes a lot of sense, but without coming across as something obvious. Each of the ‘Habits’ stands up by itself as useful advice. Added together, they mesh into a sensible structure giving an overall picture which is more than the sum of its parts.

The one thing I can see putting off some readers (particularly English ones) is Covey’s earnest tone. To quote Kate Fox’s classic, ‘Watching the English:’

“At the most basic level, an underlying rule in all English conversation is the proscription of ‘earnestness ’… seriousness is allowed, earnestness is prohibited. …To take a deliberately extreme example, the kind of hand-on-heart, gushing earnestness and pompous, Bible-thumping solemnity favoured by almost all American politicians would never win a single vote in this country.”

With this health-warning aside*, I would highly recommend ‘The Seven Habits.’ Even if you have never thought of reading a ‘self-improvement’ book in your life, I think you would find it accessible, practical, stimulating and altogether a worthwhile read.



Notes: *In writing this I realise that this blog is sometimes guilty of excessive 'earnestness' (!)

Richard Koch's The Star Principle: the Business of Winning

I recently read “The Star Principle” by Richard Koch, (businessman and the author of “The 80/20 Principle,” one of my favourite books). In it, he describes a powerful and convincing recipe for identifying successful businesses. I can recommend reading the book but for those who don’t have the time here’s my summary of it:

A star is defined as a business which is the #1 player in its market niche, and its market is growing fast (at least 20% - 30% per year). These two simple characteristics, set apart the business success stories, which make their backers tens of millions of pounds, from the run-of-the-mill businesses that just about breakeven but never make anyone rich.

• If you are founding a business, look for a gap in the market where you will be number one from the beginning. And look for a niche big enough that you can sustain rapid growth for many years. Once you establish a leadership position, do everything you can to retain it. More importantly, if you fail to get a leadership position, or you find your niche is not as big as you thought, it is better to cut your losses and direct your efforts elsewhere.

• If you are an investor, look for embryonic star businesses that you can back, where you can have an active say in their management (and ensure they remain stars).

• If you lack the resources to found or invest in a business, try your utmost to find a star business and go to work for them – the ‘first 20 people’ in on the ground floor can reap the benefits later on by getting shares or options. What’s more, working for a star business is much more fun and a much better learning experience than working for big corporates.

Koch exhorts every reader to try one of these three: found, invest in or work for a star business.

“Between 95% and 99% of businesses are not stars. For every 20 ideas you have, you can confidently junk 19 of them, because they won’t be ideas for a star venture. This saves an awful lot of money, sweat, toil and tears. Star ventures are rare...but they contribute over 95% of long-term value and probably at least 120% of the cash ever generated.”

Now every ‘recipe book for success’ needs to be read from a critical perspective (with ‘a pinch of salt’ if you will). Most importantly, if someone has found a foolproof method to ‘get rich quick’, you would reasonably expect them to spend their time executing their method, not writing about it. Well Richard Koch has already proved his entrepreneurial and investment credentials. As he describes in the book, it was his experiences with a diverse range of start-up businesses that allowed him to refine his idea of a ‘star business.’ He has been involved in five successful start-ups and made over £100m. “Koch is someone worth listening too,” wrote the Independent; this book is worth a read, as soon as you get the chance.