The lesson from chapter four of Michael Batnick’s book, “Big Mistakes: The Best Investors and Their Worst Investments,” is about depending too much on brainpower.
The author began with one of history’s most brilliant minds, Isaac Newtown, who possessed an IQ of 190 and was one of the most formidable minds in the history of science. Still, it wasn’t enough to figure out the South Sea Co. when it became one of the world’s first investment bubbles in 1720. Newton bought and sold the stock several times and had bought back in just as the stock began to crater.
He expected to double his money, but instead lost three-quarters of it, and is quoted as saying, “I can calculate the motions of the heavenly bodies, but not the madness of the people.” Obviously, he too was one of those people acting madly.
Still, Batnick said Newton was doing what too many of us do: Assuming our intelligence gives us an edge over the rest of the herd. We all believe we’re above average. And while we may be smart, we should remember there are equally smart, if not smarter, people on the other side of the trades we make.
The author pointed out that based on the qualifications to become a member of the Mensa Society, being in the top 2% of any standardized intelligence test, means there are between four and five million brilliant adults in the United States alone (6.5 million based on the 2018 census). Many of them are in the market.
Still, that isn’t necessarily a big advantage. Batnick wrote, “The chances of pulling a nine of spades out of a deck of cards is 1 in 52, but there is no way to calculate the odds of a recession given x, y, and z. With risk assets, one plus two doesn't always equal three, and the graveyard of investors is rife with people who thought they could model their way to above average investing results.”
Consider the case of what Batnick called “John Meriwether and his band of Einsteins at Long-Term Capital Management.” There’s no doubt Meriwether was a genius investor, a man who enjoyed a legendary career at Salomon Brothers, where he headed the fixed-income arbitrage group and was vice-chairman of the company.
A big part of his success came from recruiting the smartest graduates from finance and math programs at the top business schools. He recruited, for example, Robert Merton, who would go on to become a Nobel Prize winner, and many others who would have prominent careers in the industry. Batnick reported this “band of wizards” earned vast amounts of money for Salomon.
That ended in 1991, though, when Meriwether was caught up in a trading scandal involving one of his subordinates. Meriwether was forced to resign, and many of his proteges followed. In 1994, they started Long-Term Capital Management. To add even further brains to the team, Meriwether recruited yet another future Nobel Prize winner, Myron Scholes, who co-created the Black-Scholes option pricing model.
For the first several years, their apparent brilliance paid off with well above-average returns. Indeed, they quadrupled their capital and did not have a single quarter in which they lost money. But great success attracts the attention of competitors as well as clients. The firm’s secret arbitrage strategies were being copied and the investment team found it increasingly difficult to find opportunities. That prompted the partners to return $2.7 billion of their capital to the original investors.
In doing so, the firm increased its leverage from 18:1 to 28:1. And it kept going up until, at one point, it had leverage of 100:1 on $1.25 trillion in open positions. In May 1998, the firm had its first losing month because spreads between American and international bonds increased more than expected by the models. In June, it lost another 10%.
Then the bottom fell out in August as Russian stocks were down 75% for the year to date, while short-term interest rates in that country shot up to 200%. As Batnick described the situation, “And then the wheels fell off for Meriwether and his colleagues. All the brains in the world couldn't save them from what was coming.”
On Aug. 21, 1998, the firm lost $550 million, and more such days kept coming in September. Over and over, LTCM had days in which it lost tens or hundreds of million dollars. Then came the famous, or infamous, bailout. That takeover gave the partners $3.6 billion for 90% of the firm, and even those billions were lost in a matter of weeks.
Batnick asked, and answered, the obvious question: “How could smart people possibly be so stupid? Their biggest mistake was trusting that their models could capture how humans would behave when money and serotonin are simultaneously exploding.”
He also quoted “Fooled by Randomness” author Nassim Taleb, who said, “They made absolutely no allowance in the episode of LTCM for the possibility of their not understanding markets and their methods being wrong.”
According to Jim Cramer, “In short, this was a seminal blowup. It struck at the heart of all of those on Wall Street who think that this racket is a science that can be measured, structured, derived and gamed.”
Meriwether and the partners of LTCM no doubt deserved the scorn heaped upon them. Batnick closed the chapter with these words:
“They were able to calculate the odds of everything, but they understood the possibility of nothing. The lesson us mere mortals can learn from this seminal blowup is obvious: Intelligence combined with overconfidence is a dangerous recipe when it comes to the markets.”
Read more here:
- Â Big Mistakes: Mark Twain
- Â Big Mistakes: Jesse Livermore
- Big Mistakes: Even the Dean of Wall Street Made Them
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