Everyone that could, wanted to invest with Long Term Capital Management back in the mid 1990's. After all, there were some really smart people running the fund and the fund's returns were in excess of 40% - and that is after fees! The college professors and noble prize winning principals of the firm had created a system that could not fail - mathematically speaking that is.
The checks and balances were in place to safeguard the fund from any event that could ever be imagined. There was a statistical impossibility that the fund could ever lose enough at any one time period to become insolvent - or almost topple the financial system. Oops. It did become insolvent and it did almost topple the financial system.
The firm used vast quantities of historical data to arrive at their trading strategies. Most of the assumptions they made were 100% valid. However, they did not take into account the possibility of the fat tail and black swan. These are events that are not mathematically possible. But math alone can not factor in the "human element" of real-world events.
In the case of LTCM, trouble began with the East Asian financial crisis of 1997 and culminated in the default of the Russian ruble in 1998. This cataclysmic turn of events was not something that LTCM could ever had envisioned. Yet they happened.
What does this mean to the average person? That overall portfolio return MUST be integrated with sound risk management techniques to try and guard against these types of events. Sound Strategic and Tactical asset allocation models should be used because a 100% blind faith that the historical relationships between asset allocation will hold can be hazardous to your health. It is true that, over time, everything will return to the mean. Yet, can you hold on long enough for the fat tails and black swans to run their course. LTCM could not.
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