When Everyone Owns the Same Idea

Long-Term Capital Management had, by any résumé, the strongest bench on Wall Street. It was founded in 1994 by John Meriwether, the former head of bond arbitrage at Salomon Brothers. Among its partners were Robert Merton and Myron Scholes, who in 1997 shared the Nobel Prize in economics for their work on valuing options. The fund's early returns were extraordinary. Its models were elegant, and the people who built them could explain them better than almost anyone alive.

In September 1998, the Federal Reserve Bank of New York convened the heads of major banks in its offices to keep LTCM's collapse from spreading. Fourteen institutions put up about $3.6 billion to take over the fund in an orderly way. One prominent firm declined to join. Within weeks, the partners' own stakes had been largely wiped out.

The proximate cause is well known. In August 1998, Russia defaulted on its domestic debt and devalued the ruble. Investors around the world fled to the safest and most liquid assets they could find. LTCM's positions were bets that the prices of similar securities would converge, and they diverged instead. The fund was heavily leveraged, so modest moves became fatal ones.

The deeper cause is more interesting, and it is philosophical before it is financial. LTCM's models drew on history to estimate how far prices could move and how closely different markets moved together. That is reasonable, and it is also exactly what David Hume warned against two and a half centuries earlier. Nothing in the past guarantees the future. We expect the sun to rise because it always has, not because reason requires it. A model calibrated on calm years is a description of calm years.

There was a second problem, which no backtest can see. By 1998, many other firms had copied similar trades. An edge that is widely shared stops being an edge and becomes a position held by a crowd. When the crowd needs to sell at the same time, the correlations that looked stable in the data all go to one. In those weeks, diversification proved to be something the market grants in good times and withdraws in bad ones.

Mill feared the tyranny of the majority in politics: the quiet pressure of consensus that makes dissent feel eccentric. Markets have their own version. The trade that everyone sensible holds, and that the most credentialed people have blessed, is the hardest one to question from the inside.

The lesson is not that models are useless, or that brilliant people are fools. It is humbler. Every model contains a story about the world, and the most dangerous stories are the ones a whole industry tells at once. Before trusting a conclusion, it is worth asking two questions. What would the world have to look like for this to fail? And who else is relying on the world not looking like that?

Certainty borrowed from the past, and from the crowd, is still borrowed. In 1998, the loan was called.