There's this cautionary tale, in the finance world, that nearly any trader can tell you. It's about placing too much confidence in math and models. It's the story of Long Term Capital Management.The story begins back in the 90s. A group of math nerds figured out how to use a mathematical model to identify opportunities in the market, tiny price discrepancies, that they could bet big on. Those bets turned into big profits, for them and their clients. They were the toast of Wall Street; it looked like they'd solved the puzzle of risk-taking. But their overconfidence in their strategy led to one of the biggest financial implosions in U.S. history, and destabilized the entire market.On today's show, what happens when perfect math meets the mess of human nature? And what did we learn (and what did we not learn) from the legendary tale of Long Term Capital Management?This episode of Planet Money was hosted by Mary Childs and Jeff Guo. It was produced by Sam Yellowhorse Kesler and edited by Jess Jiang. It was fact-checked by Sierra Juarez and engineered by Robert Rodriguez. Alex Goldmark is our executive producer.Find more Planet Money: Facebook / Instagram / TikTok / Our weekly Newsletter.Listen free at these links: Apple Podcasts, Spotify, the NPR app or anywhere you get podcasts.Help support Planet Money and hear our bonus episodes by subscribing to Planet Money+ in Apple Podcasts or at plus.npr.org/planetmoney.Learn more about sponsor message choices: podcastchoices.com/adchoicesNPR Privacy Policy
Chapter 1: What is the story of Long Term Capital Management?
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In the mid-1990s, a group of people thought they'd finally achieved this dream that had existed since the dawn of financial markets. They'd figured out how to take risk. They built a model that could help them generate great investment returns consistently over time. Perhaps unsurprisingly, they were math nerds.
We were mostly cut from the same cloth. This is Victor Higani. He was the youngest of the group. Like we were all, you know, kind of game playing, geeky kind of people. And we just really felt attracted to the same kinds of problem solving and the same kinds of thought processes and intellectual challenges.
Victor was part of this new crew of traders on Wall Street, where before people had made investment decisions based on, like, what they thought about a company's prospects, or maybe just based on a hunch, these guys used data. Lots of data. And computers.
It was math over emotions. Risk-taking had always been an art, but now they could turn risk-taking into a science.
To a large extent, you can get rid of certain risks, but if you're going to make money, then you have to be taking risks.
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Chapter 2: How did math and models change investment strategies?
Victor had gone from working at an investment bank to getting hired into this elite, illustrious group. A group that included Myron Scholes and Bob Merton, the guys who'd figured out how to mathematically derive prices for stock options, bets on a stock's future price. For this work, Myron Scholes and Bob Merton would go on to win a Nobel Prize in economics.
Myron and Bob's model provided them with like this X-ray vision. They could spot all these discrepancies in the market where what the price should be didn't quite match what the price actually was. And the idea was those were opportunities to make money.
And Victor and his friends made so much money.
I think that we averaged like 40% annual returns, over 30%, way, way higher than what we ever anticipated was possible. They were doing amazing.
And part of their investing strategy was sometimes not investing. When the opportunities aren't good, you just shouldn't do very much.
So sometimes they didn't do very much.
Were there like game nights?
It was constantly, well, it was like game afternoon and game night. What games? Well, a lot of poker.
Poker during the day, poker at night, different types of poker. They would turn their desk chairs away from their computer screens of price charts and yield curves to face each other and ante up. They got to play games of risk and probability with actual living legends Bob Merton and Myron Scholes.
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