The Lessons of Long Term Capital Management (LTCM) and the Volatility of August 2007
I’ve been thinking a bit more about the volatility in the financial markets over the past two weeks, and I’m uncharacteristically concerned.
Normally, this would be about the time that I would write a post repeating some of my favorite personal investment staples, like:
- Don’t try to time the market
- Diversify your assets across multiple types of countries and classes
- Invest for the long term
And so forth.
Something is bothering me, though, despite the fact that I am personally following all of the above guidelines (and more) with my personal investments.
I’m worried that we haven’t internalized the warning of the Long Term Capital Management bail-out in 1998. Like the World Trade Center bombing in 1993, we may be unprepared for what that failure really signified.
As usual, Wikipedia has all the good detail on what happened with Long Term Capital Management. A hedge fund made up of literal Nobel Laureates and masters of financial risk, it utilized incredible financial leverage to take what should have been extremely low-to-no-risk opportunities and turn them into phenomenal investment gains. Unfortunately, in August 1998, some of those low-to-no-risk opportunities went in historically unpredictable ways, and Alan Greenspan had to orchestrate a multi-billion-dollar bailout from some of the large New York investment banks.
At the time, it wasn’t completely obvious to most people, even those who follow the markets, what the significance of an explosion of an single hedge fund really was. In the following weeks, months, and years, it became clear that something was fundamentally troubling about what had happened. This quote comes from Wikipedia:
The profits from LTCM’s trading strategies were generally not correlated with each other and thus normally LTCM’s highly leveraged portfolio benefited from diversification. However, the general flight to liquidity in the late summer of 1998 led to a marketwide repricing of all risk leading these positions to all move in the same direction. As the correlation of LTCM’s positions increased, the diversified aspect of LTCM’s portfolio vanished and large losses to its equity value occurred. Thus the primary lesson of 1998 and the collapse of LTCM for Value at Risk (VaR) users is not a liquidity one, but more fundamentally that the underlying Covariance matrix used in VaR analysis is not static but changes over time.
Despite being a regular reader of the Wall Street Journal, New York Times, and the occasional Economist, I didn’t really understand what had happened until I read When Genius Failed, by Roger Lowenstein (one of the books I recommend in my personal finance education series). If you haven’t read it, I highly recommend it now.
What Lowenstein explained and what I hadn’t originally appreciated is that the fundamental problem with Long Term Capital Management is a fundamental problem surrounding all of our modern portfolio theory, whether you are a small investor like me or the largest endowment.
The problem has to do with asset diversification and how it is practiced.
Portfolio diversification has become the basis of all modern investment management. The idea is to diversify your investments across asset classes with different risk factors and returns, ensuring the highest reward for the lowest risk.
For most investors, this was as simple as the traditional mix of stocks, bonds and cash. But that changed in the late 1990s.
In the late 1990s, all of a sudden, everyone wanted to be David Swensen. David Swensen was the manager who guided the multi-billion dollar Yale endowment to phenomenal returns from the 1980s through the 2000s. He even wrote a book.
David made these phenomenal gains by eschewing most traditional types of assets (public stocks & bonds). Instead, he invested in hedge funds, arbitrage, private equity, venture capital, real assets, and others). What David realized early was that you could think of many types of invesments as asset classes, and find great investment returns in non-traditional classes with risks that were not correlated to the public stock market.
This decade has seen an amazing boom in investment tolerance for non-traditonal asset classes. People freely talk about how different new investment assets have a “low correlation” to the stock market. Real estate, commodities, rare coins, art, collectibles, long/short funds, you name it. As a result, across the world, trillions of dollars are now factored into different asset classes, prudently distributed to minimize risk and maximize reward.
This would all be fine except for one thing. And it’s the one thing that more than anything led to LTCM’s demise.
That one thing is that all of these great measures of risk are based on historical records. And as all mutual fund prospectus readers know, “past history is not necessarily indicative of future performance.”
You see, you can take two things that historically have not been correlated. Asset A & Asset B. But the minute that an investor owns both A & B, there is now a correlation that didn’t exist historically. The investor is that correlation.
If Asset A goes down, and the investor needs to sell something, they may now turn to Asset B for liquidity. And that means selling pressure for Asset B, based on nothing but the asset price of Asset A. Voila, correlation.
All of those historical models don’t apply once investor behavior starts changing in mass. Maybe stocks & gold never traded together historically because the type of investor who bought gold just wasn’t the same type who bought stocks. But now, in the modern world of portfolio theory, everyone has balance. Everyone has a little of everything.
OK, ok. Not everyone. But I’m worried that enough major players do that we have created historical correlation that didn’t previously exist. That correlation is risk, and it’s risk that is not built into the models of all of these portfolios.
What’s worse, those historical models lead investors to believe that they have less risk on their books than they do have, which leads rational investors to introduce leverage into their portfolios. That means when the risk shows it’s ugly head, the results get magnified by the leverage of loans.
That’s what happened to LTCM. Their models were excellent, but they were based on historical correlation. The minute some of their investments turned the wrong way, their incredible leverage forced pressure in previously uncorrelated investments. What’s worse, other investors, smelling the “blood in the water”, discovered this new-found correlation, and pressed trades against them.
So, this scares me a lot, at least intellectually. There are very good reasons why major investors like hedge funds and other asset managers can’t share their up-to-the-minute holdings. That means, however, that no one really understands this type of “co-investment risk” that is building in mass across the markets. Unfortunately, the only way I can imagine to properly handle this risk would be to have a universal monitoring set up to accurately reflect this new type of correlation from mass “co-investment” across assets.
I’m still being a prudent investor. I still diversify my portfolio for retirement across different assets. Domestic & International, Large caps and small caps, stocks, real estate, commodities… even a long/short ETF. I don’t think I’ve sold anything based on short term movements of the markets. I’m sticking to my long term plans.
But I’m a little worried now. Intellectually, it seems like the capital markets have potentially a major risk/reward pricing problem in them right now. And these things tend not to resolve themselves quietly.
Let me know what you think.
BTW Many thanks to Igor, for asking me over dinner last week what I thought of the market volatility, and leading me to think more deeply about it.