Friday, December 18, 2009

Book Review: When Genius Failed: The Rise and Fall of Long-Term Capital Management

Here's how to lose billions of dollars over your next vacation.

In the mid 1990s, some of the brightest stars of the investing and academic universe came together to found Long Term Capital Management - the ultimate low-risk hedge fund. This was the death knell for the shoot from the hip investment broker type. Wall Street was now in the hands of the quants (people who believed in quantitative analysis to the exclusion of everything else).

Or so they thought. Using data from decades of Wall Street futures, options and equity prices, LTCM deceived themselves into thinking they had discovered immutable laws of the universe. If a price deviated from the historical norm, LTCM rushed in to make up the difference. After all, wouldn't the market eventually come to its senses, thereby benefiting the hedge fund?

The trouble with the universe, is that it is always evolving and developing new norms. LTCM began life with stellar performance. But over-reliance on mathematical models that were fundamentally incomplete ultimately spurred fantastic losses. Billions of dollars went up in smoke.

This experience in the late 1990s completely changed Wall Street. Gone were hubristic, mathematical Rube Goldberg-esque models of the universe, backed to the hilt with ridiculous amounts of leverage. Well actually, that didn't happen.

When Genius Failed, The Rise and Fall of Long-Term Capital Management is gifted financial writer Roger Lowenstein's account of the big electronic money bonfire that was LTCM.

Read it for a critique of quantitative analysis as well as deepening your sense of Wall Street history. You'll be less likely to fall for the latest thing.