The Trillion Dollar Bet - Lessons from Long Term Capital Management

A while back the PBS series "Nova" did an excellent show called "The Trillion Dollar Bet" on the rise and fall of Long-Term Capital Management (LTCM), a hedge fund founded by Nobel Laureates Myron Scholes and Robert Merton. LTCM placed massive leveraged trades in derivatives (hence the show's title) and then collapsed in truly spectacular fashion in 1998 following economic turmoil in Asia and Russia, and for a brief period threatened to take much of Wall Street with it. You can read the entire transcript online, and it's well worth a look - a fascinating window into how things can go wrong for even the most rigorously calculated and tested financial models.

At the heart of LTCM's implosion, like that of Amaranth Capital, were common problems that every trader should be aware of: the potential for unexpected drawdowns in turbulent market conditions; the fallibility of trading rules and signals that depend on past market behavior and unquestioned assumptions about future behavior; and taking on too much risk through extreme leveraging.

A number of scholars, experienced traders and fund managers appear in the show, and their observations are some of the most valuable insights I took away from it. Here are a few highlights:

Leo Melamed: "You can't ignore an error. Once you realize that you've made an error, the best thing is to get out of that error and start again fresh, and that's what a good trader does."

"That's an old market rule: the market will test you and do what you don't expect it to do."

Stan Jonas: "It was as though the world was behaving exactly the way it had been writ on the blackboard...And then slowly and totally unexpectedly, a change in the market dynamics began to become apparent."

"When do you admit that you're wrong, start all over again, or when do you hang on and assume that the markets will turn around in your way? That's the biggest decision we all have to make."

Roger Lowenstein: "Although their models told them that they shouldn't expect to lose more than 50 million or so on any given day, they began to lose 100 million and more, day after day after day till finally there was one day, four days after Russia defaulted, when they dropped half a billion dollars, 500 million in a single day."

Alan Greenspan: "How much dependence should be placed on financial modeling which for all its sophistication can get too far ahead of human judgment?"

Peter Fisher: "If a random bolt of lightning hits you when you're standing in the middle of the field, that feels like a random event. But if your business is to stand in random fields during lightning storms, then you should anticipate, perhaps a little more robustly, the risks you're taking on."

Related links:
Nova Transcript
Trillion Dollar Bet Website

Related topics:
A Cautionary Tale from an Incautious Hedge Fund
Taking On Excessive Risk