Key Lessons on the Anniversary of an Epic Investing Failure

On 22 September 1998, the Federal Reserve Bank of New York called a meeting of top executives from the U.S.’s biggest financial institutions to rescue a hedge fund that now lives in infamy in the annals of finance, Long Term Capital Management (LTCM).

LTCM opened its doors in February 1994 and by April 1998, every dollar in the fund that was invested at the start would have become $4 – it was simply put, a phenomenal success, or so it seemed. But things turned ugly quickly, so much so that a dollar in February 1994 that was in LTCM would have shrunk to around thirty cents by September 1998.

It’s been more than 17 years since LTCM had epically failed in investing, but its lessons are timeless. With today being the anniversary of the orchestration of LTCM’s rescue, it’s a good time to run through what we can learn from the saga.

1. Having intelligence does not make one a sound investor

LTCM was stocked with geniuses. Amongst its crew were two Nobel prize winners – Robert Merton and Myron Scholes – and a bunch of PhD holders.

Warren Buffett once said this about the investing firm:

“If you take the 16 of them [in LTCM], they probably have the highest average IQ of any 16 people working together in one business in the country, including Microsoft or whoever you want to name – so incredible is the amount of intellect.”

And yet, LTCM had failed. Why? See below.

2. Leverage can be really dangerous

LTCM operated with high amounts of leverage, borrowing easily $30 for every dollar it had in capital. The financial markets and economic environment are inherently volatile, and if you’re operating with borrowed money, you drastically lower the odds that you’d be able to ride out the downturn and enjoy the recovery.

It’s the same with businesses that are binging on debt. London-listed mining giant Glencore PLC announced earlier this month that it will be undertaking drastic measures – such as eliminating its dividends and selling its assets – in order to strengthen its balance sheet with its business under pressure due to falling commodity prices.

This comes after its borrowings had swelled over the past few years as you can see in the chart below:

Glencore's balance sheet

Source: S&P Capital IQ; Net-debt refers to Total debt minus Cash & Short-term investments

As a general rule of thumb, with all things being equal, companies with minimal debt on their balance sheets in relation to their cash-holdings will make for relatively less risky investments than those with balance sheets that are bloated with debt.

Companies that belong to the former camp include Super Group Ltd (SGX: S10) and Raffles Medical Group Ltd (SGX: R01); those in the latter category include Golden Agri-Resources Ltd (SGX: E5H) and Noble Group Limited (SGX: N21).

3. Intricate finance models need not reflect financial reality

Extensive reliance on its computer models for how financial assets will move had been part of the reason for LTCM’s demise; the fund’s faith in their spreadsheets and programs had emboldened them to invest with plenty of borrowed money.

Thing is, finance is a realm where models often do not fit in nicely with reality. Investor Dean Williams once gave a great analogy to explain this (emphasis mine):

“The foundation of Newtonian physics was that physical events are governed by physical laws. Laws that we could understand rationally. And if we learned enough about those laws, we could extend our knowledge and influence over our environment…

…In the last fifty years a new physics came along. Quantum, or subatomic physics. The clues it left along its trail frustrated the best scientific minds in the world. Evidence began to mount that our knowledge of what governed events on the subatomic level wasn’t nearly what we thought it would be.

Those events just didn’t seem subject to rational behavior or prediction. Soon it wasn’t clear whether it was even possible to observe and measure subatomic events, or whether the observing and measuring were, themselves, changing or even causing those events.

What I have to tell you tonight is that the investment world I think I know anything about is a lot more like quantum physics than it is like Newtonian physics. There is just too much evidence that our knowledge of what governs financial and economic events isn’t nearly what we thought it would be.”

Earlier this year, the Swiss National Bank removed a self-imposed peg on the Swiss franc which had previously kept it tight with the euro. With the peg gone, the franc shot up by around 30% overnight against a number of currencies, and caused some panic in the financial markets.

Banking giant Goldman Sachs’ Chief Financial Officer called the franc’s move a “20 plus standard deviation move,” or something which, statistically speaking, happens once every four billion years. According to science, the earth’s roughly 4.5 billion years old while humanity’s age is around 400,000 years.

My colleague Morgan Housel has a good explanation for the seeming illogicality of the situation:

“Russia defaulting on its debt in 1998, the subprime mortgage collapse [in the lead-up to the great financial crisis of 2008-09], junk bond outflows last summer, and the Swiss bank’s move last week were all moves that Wall Street models said should have only occurred once every billion years. When once-every-billion-year events happen every four years, maybe – maybe – it’s your models that are wrong.”

So, from LTCM’s experience, here’re the key lessons again: 1) Common sense can triumph intelligence in investing; 2) leverage is like dynamite on a short-fuse; and 3) computers can get it wrong, very wrong.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Chong Ser Jing owns shares in Super Group and Raffles Medical Group.