When Genius Failed: The Rise and Fall of Long-Term Capital Management
by Roger Lowenstein
Jan 2005
When hubris flailed
This is a great story. Not so much due to the breathtaking scope of financial disaster, but rather the timeless human lessons presented in such fascinating detail.
If it were a movie, the plot might be dismissed as unrealistic. The heroes (anti-heroes?) of LTCM make choices so obtuse, they literally boggle the mind. You would think the most sophisticated players in the most sophisticated markets in the world would have a keen grasp of simple things, like position sizing. These guys were nobel laureates, ubergeeks with multiple PhDs, the high quants of Salomon. You would assume they had an assortment of complex and finely tuned algorithms, implemented in real time via massive computing power, to determine the proper size of positions.
And yet, when LTCM came a cropper, it was in large part simply because their positions were too big. Not just a bit too big: ridiculously, massively, insanely too big. Technical details aside, the how of their failure is not as interesting as the why. As in Why, Oh Why did these guys think they were invincible?
Conviction cuts both ways. Without it, you can't achieve anything truly noteworthy. With too much of it, you're likely to drive yourself over a cliff. As the old saying goes… those whom the gods would destroy, they first make confident. These guys' conviction levels made UFO suicide cults look modest. I mean, when you feel strongly about something, you increase the size of your bet. If you feel very strongly, maybe you bet a significant portion of your net worth. But what do you call it when you bet not only a few hundred times your net worth, but that of your friends and clients as well… when you act with a certainty on par with the sun coming up tomorrow? At least they walked the walk; by doubling and trebling down on their own personal stakes, the partners went out of their way to ensure they had more exposure than anyone. True believers to a man.
The details are complex, but the heart of the story is simple. Genius did not just fail, it got hijacked and turned against itself. A sufficiently intelligent and creative person can convince him(or her)self of anything, no matter how outlandish, given strong enough emotional motivation to do so. Rationality was outflanked by ego, smarts subsumed by pride... in the normal world there are checks and balances on this sort of thing. If you start thinking you are a modern day Icarus, you are usually brought back to earth by various limits and circumstances (friends and family if you are lucky) before inflicting too much damage. But if the people around you actively encourage your hubris—if they whisper sweet nothings in your ear and hoist you on high—there's no telling how far your delusions may take you.
In the end, all the credentials and intelligence, all the skills and smarts presented on a silver platter, didn't mean a damn thing. This is instructive and eye opening; the emperor has no clothes. Those outside Wall Street typically assume that those on the inside know what's going on. That the monolothic skyscrapers, the PhDs in mathematics and physics, the rows of supercomputers all mean something. That these people have some intrinsic grasp of reality that the rest of us do not, that they know exactly what they are doing at all times.
But they don't. Or if they do, they can still fall prey to the reign of emotions and the folly of the human heart. This lesson is never fully learned; bigger giants will fall.
This isn't to paint all market players with the same brush. Just because LTCM flamed out in spectacular fashion doesn't mean every hedge fund is one bad day away from disaster. There are managers out there, running billions of dollars, whose success is measured in decades. But they are successful in the long term because they understand risk, they understand fallibility, and they know not to fly too close to the sun. Markets are like the ocean; you don't try to tame the ocean. You respect it, or you pay the price.
