Community blogWhen genius failed |
There's a crucial (but age old) lesson for professional and novice investors - at the end of the day the market is never wrong.
"When Genius Failed" is the title of Roger Lowensteins book dealing with the Long Term Capital Management (LTCM) collapse and the resulting bail out by the Central Banks in the US in 1998. Barely 10 years later and the financial "alchemists" must once again atone.
For those readers unfamiliar with LTCM and the stresses it placed on the market, I'll do a quick recap. LTCM was a collection of some of the brightest financial brains in the US markets who made their money peddling arbitrage opportunities using other banks money. When I say "brightest" I'm not talking about your run of the mill MBA grads - I'm talking mathematicians, rocket scientists and a pair of Nobel prize winners.
At the time of their collapse LTCM had in theory raised (and betted) nearly US$100 billion of other banks money on thousands of separate trades. When things turned against them they made the critical traders mistake of extending their investment. The spreads got wider and wider and eventually the money they were gambling couldn't cover the margins on the trades.
A decade later and scores of highly qualified business and investment students have graduated into our asset management ranks and yet we bemoan the fact that we still repeat the mistakes of the past.
Reckless lending, not quite "contained" risk in the sub-prime sector and increasing pressure on asset manager targets has seen them leverage their portfolios to breaking point to ensure they outperform their rivals. Hedge Funds themselves have emerged bigger, stronger and more aggressive and many of them have flourished in tune with booming stock markets. The pickings were easy.
Even when the cracks showed in the sub-prime market, many financial pundits pointed to the strength in the stock markets. But looking at the hits that the markets have sustained in the last 10 days or so - where do panicked investors turn? It's been so easy to make money in the market over the last few years and suddenly people are scrambling for the doors.
There's a crucial (but age old) lesson there for professional and novice investors - at the end of the day the market is never wrong.
The irony of course is that the smarter we get, the further we will try and bend the system to our will. Back when stock markets were first conceptualized, there was no such thing as leveraged instruments, short selling and arbitrage. Traders couldn't at the click of a button bet that a major banks share price would tumble. Today it might be frowned upon but is not totally unacceptable to bet millions against the share price of your own company. Even furniture salesmen are getting in on the act issuing themselves millions in of potentially lucrative share options (although I do confess it made for fascinating viewing watching millions in Rands literally just disappear).
We lurch from one cataclysmic financial event to the next all the while schooling generations of financial brains to see how far they can stretch our financial system. Can we eke out just a further 0.1% to outdo the competition? Can our auditors and financial advisors find further ways in which to expand our management mandates to reasonably increase risk while still operating within the bounds of the client's instructions?
As an industry, the banks, investment houses and their intermediaries have an irrepressible desire to evolve and develop. This in itself is not surprising - there are few industries in the world who don't look for ways to make themselves smarter, and more effective. The fundamental difference is that the financial industry does so while trying to work out how to spend other peoples' money. Traders, investors and investment gurus seem to have short memories and when times are good there are those who carry themselves with an impression of invincibility. These people need to remember - genius has failed before and genius will fail again.
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