Nobel Prize - winning economists and “genius’” Myron Scholes and Robert C. Merton were founders of Long Term Capital Management, which in 1998 lost $4 billion. That helped foster a global financial crisis and triggered both a Wall Street-led bailout and congressional hearings on the dangers of hedge funds, the freewheeling pools for wealthy investors and institutions that often trade heavily and rely on borrowed money to achieve jacked up returns. LTCM had leveraged a notional amount of $2.5B into excess of $100B of investment. NOW THAT’S GENIUS!
Over the past year there have been countless stories of banks, funds and traders, who are supposed to be brilliant, that have wiped out funds or lost significant sums of investor money, while the institutions and managers retained the nice fee’s on the assets past held. In many cases there are bailout contingencies using tax payer funds while the managers still get into their nice car and drive to their nice home.
When a fund manager or a trader establishes a risk profile for their fund, portfolio or account, it is important to consider that the market can and will do anything. By they way, I’m an institutional fund manager. In fact, at some point and time, be it sooner or later, the market will take on a movement that even the most “genius” of analysts had not anticipated. Even if a genius had anticipated the unexpected movement, what the genius does not know, nor does anybody, is the manner in which the market will move in the said, or “predicted” direction, thus challenge ones ability to manage positions around the movement. That is the great thing about trading! Genius or not, it requires the ability of a market participant to mesh their understanding of the market to that of the market environment and attempt to extract money while retaining respect for the market. The first order of business is to focus on how much you can lose. So if the first order of business is to focus on how much you can lose, then establishing a concrete risk profile for your fund is foremost and critical.
Developing well defined and reasonable risk profile for your trading typically does not require genius. Sure, the more diversified the portfolio, the more complex risk control can become, but one must always ask themselves one simple question; “What are the consequences if every position we are holding moves against us for a sustained period?”
Many managers are wondering why they did not ask themselves this question the past few months. I warned traders of the risks of trading during the month of August and suggested some directional risks they should avoid.
The reason i write this has been inspired by yet another genius fund that has failed. That of the $2.8 billion Ospraie Fund that lost 27% in August and is down over 38% for the year, with no guarantee investors will receive another 20% of the funds remaining. They claim the drop in metals and energy has contributed to the losses. I’m sure there’s more to the story, but perhaps excessive leverage (borrowing) was a contributor?
http://www.globeinvestor.com/servlet/story/RTGAM.20080903.wospraie0903/GIStory/
So traders, if you are using excessive gearing or mismanaging risk in your account/portfolio, then look at the positive… You are trading just like some of the biggest names in the business. Seriously, I would like to see geniuses put more of their study into controlling risk, rather than working tirelessly on developing new models to pull money out of the market, because sooner or later, the market will take on a direction or behavior that the risk managers had not anticipated or taken into consideration in their risk control forumula. In fact, part of the problem in larger institutions and funds, is that the developers of the models to take profit do not understand the risk management side and vise versa. Its simple, if you overlook or mismanage risk, you will eventually lose all or too much of your account.
Don’t forget to download “Face the Trader Within” by Chris Lori
Traders, I could write a book on this subject that would go into considerable detail on risk management, but i’ll leave this with you, for now.
Chris Lori
CTA
