Have you ever been in a car with a GPS that is trying to send you the wrong way up a one-way street, or leading you to make frustrating circles around your destination? We all have had similar experiences, because our GPS was using a map that didn’t quite correlate with the reality on the street. Even those who rely completely on their GPS for getting from one place to another know that they can never be 100% perfect.
Yet there is a disconnect between how sensibly we manage the valuable but imperfect GPS in our normal lives, and our inability to apply the same common sense to the valuable and imperfect tools in our investment lives. That situation has led investors to considerable grief in the past, and continues to threaten us today.
It is April 1998 and Long-Term Capital Management stands alone on the summit of the investment world. It is the most famous and successful hedge fund firm on the planet, with a four-year track record of outstanding and consistent returns. The LTCM partners are among the sharpest minds in finance, including two Nobel laureates. The sophisticated and complex mathematical models they have created give them what appears to be an unsurpassable edge versus the competition in finding and exploiting investment opportunities. Yet four months later they are history, after nearly taking down the financial system with what turns out to be a collection of massively overleveraged and illiquid investments.
LTCM did not fail because of the hubris or greed of the partners. It did not fail because of a rogue trader’s mistake or any of the other dramatic reasons that normally lead to Wall Street flame-outs. What made LTCM’s principals stand out was their quiet, methodical and totally academic demeanor. They believed in their models, and did not deviate from them; even if markets moved severely against them, they quietly kept investing.
It always worked. And that was their undoing. Their quiet confidence led them to make a simple, avoidable and rather mundane oversight: They confused their models with real life.
The LTCM partners were legitimate geniuses, and we might forgive them for thinking that maybe they were just a bit smarter than anyone else and therefore their models were that much better as well. In fact their models were a lot better than anyone else’s; but at the end of the day they were just models; that is, they were abstract representations of the real world.
Long-Term Capital Management might still be in existence today had there been posted throughout its offices this wonderful piece of wisdom from George E.P. Box: “All models are wrong, but some are useful.”
Still Overconfident
Fifteen years after the LTCM disaster the investment world is not merely ignoring the lesson, it is promoting the mistake. Conventional wisdom today is that investment success is directly related to finding and sticking to a successful model; and the more successful the model, the more you need to rely on it (and only it) as a guide for your investment decisions.