Business

When Genius Failed: 8 key ideas

by Roger Lowenstein

The core ideas of When Genius Failed, each in under a minute, written in our own words. Want the full depth? Get the book.

1. IDEA 1 OF 8

   Brilliant minds built a hedge fund

   Lowenstein tells the story of Long-Term Capital Management, a hedge fund founded in 1994 by John Meriwether and staffed by star traders and Nobel Prize-winning economists.

   Investors believed its mathematical models could make steady profits with little risk.

2. IDEA 2 OF 8

   Models promised safety

   The fund used models to find small price differences between related assets.

   Its partners believed these trades were nearly risk-free. In Lowenstein's account, the partners were very clever, and they trusted the maths to tell them when a trade was safe.

3. IDEA 3 OF 8

   Profits came early

   LTCM earned spectacular returns in its first years.

   Its success attracted huge investments. In Lowenstein's account, the early success made the partners and investors confident that the method would keep working. This made the fund look unbeatable.

4. IDEA 4 OF 8

   Borrowing multiplied risk

   To make large profits from small differences, the fund borrowed enormous amounts.

   This leverage magnified both gains and losses. In Lowenstein's account, borrowing made a small trade look big, but it also meant a small mistake could become a very large loss.

5. IDEA 5 OF 8

   A crisis broke the models

   In 1998, Russia defaulted on its debt, causing panic in markets.

   Prices moved in ways the models had not predicted. In Lowenstein's account, the models assumed that markets would behave as they had in the past, but this crisis was different.

6. IDEA 6 OF 8

   Losses mounted quickly

   LTCM lost billions within weeks.

   Its huge positions threatened other banks. In Lowenstein's account, because the fund owed so much to others, its trouble soon became a worry for the wider financial system.

7. IDEA 7 OF 8

   A rescue was arranged

   The Federal Reserve organised a rescue by major banks to prevent wider damage.

   The fund was wound down. In Lowenstein's account, officials feared that a sudden collapse could harm many other firms, and so the banks agreed to step in.

8. IDEA 8 OF 8

   Models have limits

   Lowenstein argues that the fund's leaders trusted their models too much.

   Markets can behave in unexpected ways. In Lowenstein's view, a model is a simplified picture of the world, and it can fail when something unusual happens.