When Genius Failed by Roger Lowenstein

When Genius Failed: The Rise and Fall of Long-Term Capital Management by Roger Lowestein details how a firm so widely regarded in the financial industry can collapse in a span of few months.

Long-Term Capital Management (LTCM) was founded in 1994 by John Meriwether. Prior to LTCM, John worked at an investment bank, Salomon Brothers, as a bond trader before becoming the vice-chairman of the company. With his experience at Salomon Brothers and his mathematics background, John brought in various academics including Myron Scholes and Paul Merton, who won the Nobel Prize in Economics. This emphasis on computer research and data analysis was uncommon at the time and gave LTCM a mystique around how they identified investment opportunities.

Coupling extensive computer research along with the theory that bond yield spreads eventually converge, LTCM traders were confident in their analysis and made unparalleled returns in their first few years by being highly leveraged. With all the momentum on its side and LTCM being greatly heralded in the financial industry, LTCM traders became more reckless in their trading. They leveraged more, invested with their private funds, and started to enter markets they were not familiar with.

Leverage allows you to invest money which you don’t have. However, on the down side, you can suffer great losses if your investment doesn’t pan out. With the financial crisis in 1997 and 1998, this impacted many markets and LTCM quickly found all its leveraged positions plummeting in value. From a net worth of 3.6 billion, LTCM lost all its value in a span of few months and entered bankruptcy as it watches Russia defaulted on its currency bonds.

The key takeaway I walked away is the importance of discipline when it comes to trading. During a bull run, people often times fell into a trap of having a sense of invincibility and will start to make uncharacteristic trades in an effort to yield higher returns. The most consistent thing is uncertainty and even though market research is important, the future is not a simple extension of past trends.