When Genius Failed: The Rise and Fall of Long-Term Capital Management

by Roger Lowenstein

betting on IOs is like betting on interest rates. But the partners didn’t want to forecast rates; such outright speculation made them jittery, even though they did it on occasion. Because interest rates depend on so many variables, they are essentially unpredictable. The partners’ forte was making highly specific relative bets that did not depend on broad unknowns.

“If markets behave as they have in the past, how much will we lose?” But what if markets did something different? History, Mark Twain noted, rhymes; it does not repeat.

Scholes described Long-Term in refreshingly plain terms: “What we do is look around the world for investments that we think are, because of our models, undervalued or overvalued. And then we hedge out the risk of something we don’t know, like a market factor.”27

Unlike dice, markets are subject not merely to risk, an arithmetic concept, but also to the broader uncertainty that shadows the future generally. Unfortunately, uncertainty, as opposed to risk, is an indefinite condition, one that does not conform to numerical straitjackets. The professors blurred this crucial distinction; they sent their mathematical Frankenstein gamely into the world as if it could tame the element of chance in life itself. No self-doubt tempered them; no sense of perspective checked them as they wagered such staggering sums.