Long-Term Capital Management

The Devil’s Advocate™ →Go uptown Complex systems present as “wicked problems”. They are dynamic, unbounded, incomplete, contradictory and constantly changing. They comprise an indefinite set of subcomponents that interact with each other and the environment in unexpected, non-linear ways. They are thus unpredictable, chaotic and “insoluble” — no algorithm can predict how they will behave in all circumstances. Probabilistic models may work passably well most of the time, but the times where statistical models fail may be exactly the times you really wish they didn’t, as Long Term Capital Management would tell you. Complex systems may comprise many other simple, complicated and indeed complex systems, but their interaction with each other will be a whole other thing. So while you may manage the simple and complicated sub-systems effectively with algorithms, checklists, and playbooks — and may manage tthe system on normal times, you remain at risk to “tail events” in abnormal circumstances. You cannot eliminate this risk: accidents in complex systems are inevitable — hence “normal”, in Charles Perrow’s argot. However well you manage a complex system it remains innately unpredictable. In which the curmudgeonly old sod puts the world to rights. Index — Click ᐅ to expand: The Devil’s Advocate Tell me more Sign up for our newsletter — or just get in touch: for ½ a weekly 🍺 you get to consult JC. Ask about it here.

What happens when you try to manage a complex system with complicated tools.

See also: Hubris.

LTCM was a hedge fund, founded in 1993, and stuffed to the gunwhales with splendid brainboxes and Nobel prize-winners, including at least one of the team who “solved” the problem of how to accurately price options with the Black-Scholes option pricing model. LTCM used their braininess, and the Black-Scholes model, to engage in leveraged arbitrage, ultimately doing the world the large favour of testing the Black-Scholes model to destruction.

Destroy it they did, alas, in the process destroying their fund, and nearly taking the entire financial system with them.

But at least we now know that the Black Scholes model is only reliable when you don’t really need it, in times of relative market calm, so everyone has learned only to use it to manage positions that do not have any tail risk, not even once in a gazilion years, anymore.

Then those “ten-sigma” events — like, ooooh, say the correlation of a Russian government default with a spike in the price of all other G20 Treasury securities, just to pick something at random — that should, in the world of normal distributions, happen only once in every 1 x 10²⁴ times — say, every hundred million years or so — but, since investment decisions are not, even remotely independent events, happened once — and only needed to happen once, to blow Long Term Capital Management and much of the market to smithereens — just four years after they started trading.

See also

A good collection of the JC’s book club books relate.

• Inventing Money
• When Genius Failed
• Models.Behaving.Badly