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Overview

Icarus was given a pair of wings made by his father, Daedalus. He flew with those wings until he got too close to the sun and the wax holding them together melted. Icarus fell into the sea below and drowned.

In this famous story, Icarus flies too close to the sun and his wings melt. This fable can be used as a metaphor for Long-Term Capital Management (LTCM), which dominated financial markets in the 1990s. Like Icarus, they were very successful but then went too far and crashed due to their own hubris. The key points of this passage will provide you with an important reminder that no company or person should think they are better than everyone else because it’s impossible for them to beat the market on their own. In these key points you’ll discover why we’re not rational when making decisions; also academics might not be good at giving advice about money because they don’t have enough real world experience.

Big Idea #1: Long-Term Capital Management was an enormous hedge fund that made its money through arbitrage.

The 1997 Asian financial crisis and the 1998 Russian default are two events that are probably much more familiar to you, as they brought the financial world to the brink of collapse. LTCM had an important role to play in both.

LTCM was a hedge fund that was founded in 1994 by trader John Meriwether. Hedge funds are managed by small groups of mostly wealthy investors, and they invest their money in ways not subject to the same regulations as mutual funds, which manage investments of larger groups of people.

Hedge funds aren’t regulated, which is why they can invest in riskier financial products. The LTCM (Long Term Capital Management) fund used a strategy called arbitrage to make money by buying and selling these risky products.

To show this, imagine that the same company sells two stocks in different markets. Since they’re from the same company, you’d expect both stocks to be at the same price. However, sometimes one stock may dip below another and offer an opportunity for quick profit-making by buying before those prices are equalized again.

In reality, the dynamics of the financial market aren’t that simple. The price discrepancies in financial products are often small and quickly disappear.

LTCM (Long-Term Capital Management) was a hedge fund that used academic calculations and computer software to find opportunities in the market. They became the largest hedge fund ever, so what happened?

Big Idea #2: LTCM leveraged heavily in order to maximize their profits.

Hedge funds make bets on tiny differences between the present and future price of financial products. This requires large investments, so hedge funds can’t generate a lot of profits with only small discrepancies in prices.

Although hedge funds have a lot of money, they need more to maximize their potential returns.

So, Long-Term Capital Management (LTCM) borrowed a lot of money and encouraged others to do the same. Banks were happy to lend them lots of cash because LTCM’s strategy was supposedly very safe from market swings. Even if there was a sudden decline in the stock market, they wouldn’t lose much money. That’s what they thought anyway.

Lending institutions were happy to lend money to LTCM because they believed that the investments would be profitable. For example, with only $1.25 billion in capital, LTCM could borrow enough money to invest about $20 billion.

Banks made these investments because they didn’t understand the risks.

LTCM was able to invest in whatever they wanted, and banks trusted them with their money. The banks didn’t have control over where the money went. At that time, this was fine because LTCM were experts who could make good investments for the banks’ money. But then LTCM made some bad investments and lost a lot of money, which caused problems for the banks that had given them all that borrowed money to invest with.