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Book Reviews |
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When
Genius Failed: The Rise and Fall of Long-Term Capital Management by Roger
Lowenstein |
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Click on title or picture to buy from amazon.com |
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“Numerical Straitjackets” What were they thinking? According to
Roger Lowenstein, it seems that the partners in Long-Term Capital Management thought
they were smarter than everybody else. Some of them had the Nobel prize in
Economics to prove it. Lowenstein tells a gripping story in When Genius
Failed: The Rise and Fall of Long-Term Capital Management. We learn a lot
more about the reclusive John Meriwether than we picked up from Michael
Lewis’ Liar’s Poker. Less a gambler and more of a calculated risk taker,
Meriwether distinguished himself on Wall Street by hiring very smart people
to create models to help understand bond markets. After leaving Salomon
Brothers, Meriwether formed a hedge fun, run by the smart team he brought
from Salomon and advised by Nobel prize winners Robert Merton and Myron
Scholes. “A central tenet
of the partners’ philosophy was that markets were steadily getting more effiucient,
more liquid, more “continuous”---more as Merton had envisioned them. With
more investors hunting for mispriced securities and with market news
traveling faster, it seemed logical that investors would take less time to
correct mistaken prices. And on most days, they probably did. An efficient
market is a less volatile one (it has no Black Mondays) and, from day to day,
a less risky one. Spreads should therefore contract. This boosted the
partners’ confidence that spreads would narrow. Indeed, they were confident
enough to leverage such bets many times over.” Lowenstein interviewed many of the players
involved in the creation of LTCM and had access to many documents that helped
unravel exactly what happened. Lowenstein walks the reader through the drama
with clear explanations of what happened and why. Economics is more art than science, and
this book confirms that. The models assumed that the future would behave like
the past, in a rational manner. Their mathematical precision, backed up by
their academic credentials, and prior success attracted huge amounts of money
into the hedge fund. “Long-Term was so self-certain as to believe that the
markets would never---not even for a wild swing some August and
September---stray so far from its predictions.” Their decline occurred
because human and market behavior isn’t always rational and predictable. LTCM faced what many others have faced in
the past: when they needed to sell, no one was there to buy. “Reared on Merton’s
and Scholes’s teachings of efficient markets, the professors actually
believed that prices would go and go directly where the models said they
should. The professors’ conceit was to think that models could forecast the
limits of behavior. In fact, the models could tell them what was reasonable
or what was predictable based on the past. The professors overlooked the fact
that people, traders included, are not always reasonable. This is the true
lesson of Long-Term’s demise. No matter what the models say, traders are not
machines guided by silicon chips; they are impressionable and imitative; they
run in flocks and retreat in hordes. Even when traders
get things “right,” markets can hardly be expected to oscillate with the
precision of sine waves. Prices and spreads vary with the uncertain progress
of companies, governments, and even civilizations. They are no more certain
that the societies whose economic activity they reflect. Dice are predictable
down to the decimal point; Russia is not; how traders will respond to Russia
is less predictable still. Unlike dice, markets are subject bit merely to
risk, an arithmetic concept, but also to the broader uncertainty that shows
the future generally. Unfortunately, uncertainty, as opposed to risk, is an
indefinable condition, one that does not conform to numerical straitjackets.” This is a compelling story about people
who thought they were smarter than everyone else. Read about the investors
who lost 77% of their capital at a time when the ordinary stock market
investor had been more than doubling his money. Eavesdrop on the maneuverings
and cooperation among Wall Street players. Learn a lesson or two about the
limits of predictions. Steve Hopkins, October 2, 2000 |
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ã 2000 Hopkins and Company, LLC |
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