Six lessons from the collapse of LTCM
One of the most dramatic financial collapses in history happened 25 years ago this month.
The demise of the hedge fund Long-Term Capital Management (LTCM) provides important lessons. Yet many investors, including many professionals, have yet to learn them.
"Those who fail to learn from history are doomed to repeat it."
— Winston Churchill
LTCM launched in 1994, the brainchild of a group of prominent academics, including Nobel laureates Myron Scholes and Robert Merton. Between them, they developed sophisticated mathematical models for pricing options and managing risk.
These models were based on historical market behaviour. They were designed to identify arbitrage opportunities and profit from small price discrepancies between various financial instruments.
For a time, LTCM appeared to be very successful. It generated large profits and attracted sizeable investments from institutions and wealthy individuals.
But, in 1998, a series of unforeseen events resulted in huge losses for the fund. LTCM's positions were highly leveraged — in other words, it had borrowed money to place bets. Those bets turned sour when Russia defaulted on its debt, causing market turmoil. The fund’s high level of borrowing magnified its losses.
LTCM also had liquidity issues, which meant the fund’s managers struggled to exit their positions without incurring even further losses.
Eventually, the crisis threatened not just LTCM’s own survival but also the stability of the global financial system. A consortium of major banks and financial institutions stepped in to bail the fund out. That prevented what could have been a catastrophic chain reaction across the markets.
What it teaches us
What lessons can investors learn from the collapse of Long Term Capital Management?
1. Risk management is crucial
LTCM's downfall highlighted the critical importance of effective risk management. The fund used complex models to manage risk. However, these models failed to account for extreme volatility resulting from Russia's debt default. Proper risk management means preparing for all eventualities.
2. Expect the unexpected
The LTCM collapse was a classic example of a "black swan" – an unforeseen and rare event with significant consequences. It serves as a reminder that such events can and do occur, and you need to be ready for unexpected shocks.
3. Don't rely on models
LTCM relied on mathematical models that worked well in normal market conditions but failed during times of crisis. It shows that quantitative models have their limitations. Markets can deviate from historical patterns, especially during times of stress or uncertainty.
4. Beware hubris and arrogance
The founders of LTCM were very bright, successful individuals, including Nobel laureates. This may have led to overconfidence in their models and strategies. Hubris and arrogance are a real danger in investing. Always remain open to the possibility of being wrong.
5. Be cautious about leverage
LTCM's reliance on borrowing money to amplify its bets contributed to its losses. Leverage can magnify gains, but it can also lead to catastrophic losses if the market moves against your position. Most investors should steer clear of leverage altogether. Don’t borrow money to invest yourself — and don’t invest in funds that adopt leveraged positions.
6. Think about liquidityThe crisis highlighted the importance of liquidity. When a fund is in distress, and investors rush for the exits, things can soon go from bad to worse. The collapse of LTCM is a reminder to investors to think about liquidity and to avoid investing in anything it might be hard to get out of.
History will repeat itself
Looking back at what happened to LTCM, the obvious question is, will it happen again?
The answer is a definite yes. In fact, we've seen several times over the last 25 years the same mistakes repeated. There were echoes of LTCM, for example, in the global financial crisis. There are similarities too with the collapse of Neil Woodford’s investment empire and the bursting of the crypto bubble.
There are bound to be many more examples in the future of investments that look like one-way bets. It’s human nature to want to get on board. There’s nothing wrong with risking a small amount of your portfolio on a speculative investment — if that's what you want to do. But doubling down on such a risk is foolhardy in the extreme.
Victor Haghani, one of the partners in Long Term Capital Management, has just co-written a book called The Missing Billionaires. (1) In it he explains how, as a successful trader, he was already very wealthy for a man in his mid-30s when LTCM launched. But he chose to invest 80% of his family’s money in the fund — a decision he sorely regrets.
“In investing, the natural tendency is to focus on the question of what to buy or sell,” he writes. “Nearly 100% of the financial press is dedicated to this question, so it’s reasonable to suppose that the ‘what’ decision is the most important thing we should be thinking about. It isn’t.
“The most important financial decisions you need to get right are of the ‘how much’ variety.”
So next time you read of a fund that looks like a money-making machine, ask yourself a simple question. Do you really want to risk the money you already have and need, in the hope of making a fortune you don't have but don't need either? The answer indeed has to be no.
This article is produced by us for Financial Advisers who may choose to share it with their clients. Timeline Planning and Timeline Portfolios do not offer direct-to-consumer products
Robin Powell is a journalist, author and editor of The Evidence-Based Investor.