In 1994, the hedge fund world had its eyes on a promising new fund called Long-Term Capital
Management (LTCM). Their star-studded roster was packed with financial industry heavy hitters
of the Modern Portfolio Theory (MPT) and efficient market inclination. It was an opportunity
to, on a global stage, prove the validity of the underpinnings of the stock and bond
only buy and hold strategy. Yet… when it ultimately failed miserably… pundits and
‘experts’ continued to sell the same easy narrative to the investing public.
Welcome back you beautiful 17,000 subscribers. Disclaimer: this is an unpopular opinion.
But it’s something I’ve dedicated years of my career to understanding. Because, if
I’m right on this… investors should know. You should know. The people we care about
should know. So, I hope you’ll hear me out over these next few videos and let me know
in the comments what you think as we go. Open and honest discourse: that’s how we can
all best learn together. Alright, back to the story…
LTCM was founded by Wall Street heavyweight John Meriwether, the former vice-chairman
and head of bond trading at Salomon Brothers. (He’s a big deal!) With his influence, he
was able to attract the best traders in the industry …and beyond—his pull stretched
into academia where he even attracted the likes of two Nobel laureates.
Anyone who has ever traded or studied stock options is familiar with the Black-Scholes
model for pricing these popular derivatives. Investopedia defines this model as follows:
The Black-Scholes model, also known as the Black-Scholes-Merton (BSM) model, is a mathematical
model for pricing an options contract. In particular, the model estimates the variation
over time of financial instruments. It assumes these instruments (such as stocks or futures)
will have a lognormal distribution of prices. Using this assumption and factoring in other
important variables, the equation derives the price of a call option.
Myron Scholes and Robert C. Merton, two of the academics behind this esteemed model,
signed on with Meriwether. The models they built for LTCM were rooted in the idea of
efficient markets and “a lognormal distribution of prices.” In other words, they were using
past data to make “sure bets” about what would happen in the future.
That’s the same founding principle behind modern portfolio theory and the stock-and-bond,
buy-and-hold strategy touted by so many ‘experts’ today.
Put simply, their models—“definitively proven” by historical data and backward-looking
analyses—would identify arbitrage opportunities in the market. Then, LTCM’s traders would
go to work, leveraging their immense portfolio to the extreme in order to squeeze every last
dollar out of each and every opportunity.
Alright, the stage is set. It’s time to put these historically based academic theories
to the test—that is, these theories that are reliant upon the same dataset and logic,
as is that cliched buy and hold strategy—to “definitively” draw our conclusions as
to whether or not we can absolutely rely on this historical data to draw our forward-looking
conclusions (as they were doing here and as a buy-and-hold advocate would be …well,
advocating). –
To the LTCM partners—and to the many high-profile banks and investors who fell all over each
other to get a piece of the pie—their strategy was foolproof. With the salesmanship of Merton,
Meriwether, and Scholes, by the time they launched in February 1994, the fund had amassed
more than $1B in start-up capital—an unprecedented feat for a brand-new hedge fund.
The firm was wildly successful at first, generating returns of 28% in 1994, 59% in ’95, and
57% in ’96. In 1997, LTCM still managed to realize another 25% despite controlling
more than $100B in assets.
In his brilliant book, When Genius Fails, Roger Lowenstein observed:
Merton’s theories were seductive not because they were mostly wrong but because they were
so nearly, or so nearly often, right. As the English essayist G. K. Chesterton wrote, life
is ‘a trap for logicians’ because it is almost reasonable but not quite; it is usually
sensible but occasionally otherwise. ‘It looks just a little more mathematical and
regular than it is; its exactitude is obvious, but its inexactitude is hidden; its wildness
lies in wait.’
To most, it seemed as though they had cracked the code. There were a few reputable names
in finance, however, who expressed concern with LTCM’s overconfident reliance on past
data. Most notably, Paul Samuelson, the first economist to win a Nobel Prize and Merton’s
MIT mentor, had his doubts from Day 1. “The essence of the Black-Scholes formula,” Samuelson
observed, “is that you know, with certainty, not what the deal of the cards will be but
what kind of universe is being sampled.” (That—this—is important. We’ll come
back to it in a later video.) Lowenstein elaborates:
The beauty of cards is that the universe is known; there are 52 cards in a deck, and only
52. Life insurance is a bit different: since new people are always being added to the universe,
actuaries rely on samplings. They aren’t perfect, but they work, because the sample
of people is very large and mortality rates change only very slowly. But in markets, we
are never sure that the sample is complete. The universe of all trades looked one way
throughout the 1920s and another way after the Great Depression. The pattern changed
again during the inflationary 1970s, yet again in the effervescent 1990s. After which of
these periods was the picture ‘normal,’ and how do we know that the next new period
won’t change the story again?
We will never have a complete dataset when it comes to stocks and markets and economies.
One thing we can be sure of, however, is that the story for each new period will—in some
likely unanticipated way—be different.
At the end of 1997, the story did indeed change. Long-Term Capital Management was highly exposed
to a (...ready?) “one-of-a-kind” financial crisis in Asia. This was an event for which
Merton’s and Scholes’s historically based models had not prepared. But the fund survived
… That is until the following year when yet
another “one-of-a-kind” financial crisis wreaked havoc in Russia. The Russian government
defaulted on its domestic local currency bonds—a decision very few thought possible … especially
those at LTCM with their backward-looking data.
By the end of August 1998, the fund had lost more than $1.85B worth of capital. Lowenstein
offers this perspective:
Theoretically, the odds against a loss such as August’s had been prohibitive; such a
debacle was, according to the mathematicians, an event so freakish as to be unlikely to
occur even once over the entire life of the Universe and even over numerous repetitions
of the Universe. But it had happened to Long-Term not quite four years after Meriwether had
written to the firm’s investors, confidently endorsing Merton and Scholes’s so finely
tuned assumptions …
According to their mathematical models, the financial fluctuations that resulted from
these rare events were for all intents and purposes … impossible. Yet, the “historically
based impossible” seemed to keep happening to them. In the first three weeks of September,
Long-Term’s actual equity crashed from $2.3B to $400MM. The fund effectively lost 92% in
1998 before, under pressure from the Federal Reserve, a consortium of Wall Street banks
reluctantly bailed them out (so, it would have been even more).
Long-Term Capital Management put Modern Portfolio Theory’s backward-looking logic to the test.
It’s the same logic used to promote the buy and hold strategy: because it’s worked
in the past, it’s obviously going to work forever into the future… LTCM’s remarkable
failure took place on the world stage. Yet here we are—advisors, pundits, and academics
still trying to use historical data to predict forever into the future in order to tell you
what to do.
We’re just getting started exploring these issues together. I mean… I wrote an entire
book on the subject after all. I explore the logical fallacy behind buy and hold in even
more entertaining detail in this video (if it’s not there yet, I’m still editing
it, so you should probably subscribe and make sure notifications are on), or in the meantime,
you could check out this video which elaborates on a few potential suggestions for better
ways to invest. Don’t forget to say hey in the comments. I wanna help. Take care.