Planetary Delights

I found Roger Lowenstein's essay on the history of LTCM crisis and how it was a fire-drill for the wreck that has come after it in the markets. There were so many delightful quotes in this one, I figured I'd pull a few.

AS striking as the parallel is to Bear, Long-Term Capital’s echo is far more profound. Its strategy was grounded in the notion that markets could be modeled. Thus, in August 1998, the hedge fund calculated that its daily “value at risk” — meaning the total it could lose — was only $35 million. Later that month, it dropped $550 million in a day.

How could the fund have been so far off? Such "risk management" calculations were and are a central tenet of modern finance. "Risk" is said to be a function of potential market movement, based on historical market data. But this conceit is false, since history is at best an imprecise guide.

Risk — say, in a card game — can be quantified, but financial markets are subject to uncertainty, which is far less precise. We can calculate that the odds of drawing the queen of spades are 1 in 52, because we know that each deck offers 52 choices. But the number of historical possibilities keeps changing.

I think about this a lot. It's the difference between believing the world is 2D vs 3D, the conceit that you can know all of something vs the hope that you've captured enough to do well. As I get older, I am simultaneously intrigued (seduced?) by the idea of what numbers can model at the same time I fear that all of it is wrong.

Modern finance is an antiseptic discipline; it eschews anecdotes and examples, which are messy and possibly misleading — but nonetheless real. It favors abstraction, which is perfect but theoretical. Rather than evaluate financial assets case by case, financial models rely on the notion of randomness, which has huge implications for diversification. It means two investments are safer than one, three safer than two.

The theory of option pricing, the Black-Scholes formula, is the cornerstone of modern finance and was devised by two Long-Term Capital partners, Robert C. Merton and Myron S. Scholes, along with one other scholar. It is based on the idea that each new price is random, like a coin flip.

Long-Term Capital’s partners were shocked that their trades, spanning multiple asset classes, crashed in unison. But markets aren’t so random. In times of stress, the correlations rise. People in a panic sell stocks — all stocks. Lenders who are under pressure tighten credit to all.

A further wrinkle that complicates thinking. The first quote implies that life is random, and no model will ever incorporate all of the variables. The second: life isn't random, and people often move in herds. The hard part to keep in mind: both statements are true.

Investors, meanwhile, could help themselves by preparing for the next 100-year flood. Rest assured, it will arrive before then.

It's so so hard as a human to remember that a "100 year flood" doesn't mean it will happen every 100 years. It could happen a lot more often and then not at all for awhile, or it could not happen for 200 years. That's really hard to keep in the back of your head when you think about it: a hundred-year flood could happen tomorrow. Or the next day. Or the next day. And then two days in a row. It's all very very random.

Ultimately, it's the challenge of believing that two contradictory facts are both true. The divisions we too often create to make sense of the world: right vs wrong, either or don't express well enough the world around us. Everything is pleasant shade of colorful gray.