Long-Term Capital Management (LTCM) was a hedge fund founded in 1994 by financial experts, including two Nobel Prize winners in Economics. LTCM’s mathematical models indicated that the probability of losing 85% of its money was once in the lifetime of several universes. But after 4 years of stellar returns, LTCM collapsed and almost brought down the U.S. banking system.
Beware of geeks bearing formulas.
Nassim Taleb is a mathematician and former financial trader. In his book The Black Swan, Taleb describes “black swans” as highly-improbable events with massive impact. He says:
I recommend two things. Number one, take the maximum amount of risk and other forms of exposure to positive black swans when this costs you very little if you’re wrong and earns you a lot if you’re right. Number two, minimize your exposure to negative black swans.
For example, Taleb invests using a “barbell strategy”. He puts 85–90% of his money in ultra-safe investments such as U.S. treasury bonds. The remaining 10–15% goes to high-risk, high-reward bets.
In life, negative black swans include:
Driving while drunk or sleepy
Doing extreme sports
Visiting high-crime cities or countries
Giving control of life savings to a financial advisor
Leaving a child alone with an adult male (1% of men are pedophiles, which means a city of 1 million has about 5,000)
It does not matter how frequently something succeeds if failure is too costly to bear.
Positive black swans include:
Most people never pick up the phone, most people never ask. And that’s what separates the people that do things from the people that just dream about them. You gotta act. And you gotta be willing to fail.
Allington NFB, McCombie JSL, Pike M. (2012). Lessons not learned: from the collapse of Long-Term Capital Management to the subprime crisis. Journal Post Keynesian Economics. 34(4): 555–582.
Long-Term Capital Management (LTCM) was a hedge fund founded in 1994 by 11 partners including Myron Scholes and Robert Merton (winners of 1997 Nobel Prize in Economics)
According to LTCM’s financial models, the probability of losing 85% of its value was once in the lifetime of several universes
Returns after fees were 20% (1994), 43% (1995), 41% (1996), and 17% (1997)
At the beginning of 1998, LTCM had $4.8 billion in equity and $124.5 billion in debt (leverage ratio of 25:1)
LTCM collapsed in September 1998, having reached a leverage ratio of 250:1
Webb A. (2008, December). Taking improbable events seriously: An interview with the author of The Black Swan. McKinsey Quarterly. https://www.cbsnews.com/news/taking-improbable-events-seriously-an-interview-with-the-author-of-the-black-swan/
Tenbergen G et al. (2015). The neurobiology and psychology of pedophilia: Recent advances and challenges. Front Hum Neurosci. 9: 344.
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