I recently watched Eric Rosenfeld’s lecture to MIT students about LTCM and what really happened. Rosenfeld was a partner at LTCM, so he definitely had the inside scoop.

The video is a bit blase if you don’t want to spend an hour and a half listening to an academic talk about why LTCM wasn’t really wrong, despite losing billions of dollars… but it does help the rest of us understand how some of the people in the room actually think about things, and it does carry at least one very important lesson…

Academics ultimately view of the markets in a fundamentally wrong way — at least as Mr. Rosenfeld explains it.

Here’s one of the biggest problem Mr. Rosenfeld doesn’t understand.

  • Risk is not the same thing as price fluctuations (or the standard deviation of price fluctuations).

In the presentation Rosenfeld makes several comments about how low the risk was in LTCM’s portfolio, for which the evidence was the low daily and monthly standard deviations of the portfolio.

Obviously they didn’t understand the actual risk present in their trades is not the same thing as the price fluctuations. Someone was referring to Rosenfeld’s guest lecture as an attempt at revisionist history, but in reality I think he still misses this fundamental reality of risk.

Let’s imagine that we have a stick of dynamite. It has a long fuse that takes 30 seconds to burn through. Suppose I put on a trade where I hold the dynamite for 20 seconds in exchange for some premium… tossing it into the distance after the 20 seconds.

If I never had my hand destroyed by an errant explosion, I can convince an academic or a banker that there was no risk in the activity. No risk you say? NO RISK. Well, with no risk, we can offer you 10-to-1 leverage on that kind of trade…

So, you tell me… if I take that trade and hold a stick of dynamite for 20 seconds, have I really participated in a trade that has very, very small risk? Does this argument sound familiar? It should, it’s the crux behind The Black Swan, where Nassim Taleb makes a very similar point.

At the end of the day, any time you use leverage you are taking on the risk of failure. Not just of you, but also for your creditor. Take on ridiculous leverage, and you almost guarantee you will bust at some point in time. You guarantee that if/when a crisis hits, you will be one of the weak hands that liquidates. And you will liquidate not based on your own judgement, but rather on someone else’s judgement (the margin clerk’s).

It is difficult enough to trade a multi-billion dollar hedge fund due to liquidity of the funds you invest in… how much more risky is it when you can’t close a position because your leverage makes you a much larger portion of the market you are trading in?

Want a little refresher on what LTCM actually did do? Check the following 6 minute video for a little hyperbole….