This Week, I Learned About A Financial Scientist ...

This week, I learned about a financial scientist named Myron Sholes. In the early 1970s, he and some colleagues figured out how to price stock options. He also figured out the implication of his own formula – that if you could just diversify into enough investments – you could in theory, eliminate risk. Myron Sholes’ formula was so powerful that it earned him a Nobel Prize in 1997. It also got him a job on what Wall Street called ‘The Dream Team’ in 1994.

This company called Long Term Market Capital put together 12 of the most respected names in finance, and proceeded to pull in $3 billion worth of capital in a fund so exclusive and so secret that even investors weren’t allowed to know what the fund was doing. They simply had to accept on faith that Sholes and Merton and these other guys knew what they were doing. And they did – in droves.

In fact, for three years, they were pulling in nearly 40% returns annually. It was going great.

But there was a problem with Sholes’ formula. You see, it did a great job of predicting prices based on past performance. But if you have ever even thought about a stock or a bond or a mutual fund, I know you this warning: “Past Performance is no guarantee of future results.”

Well, Sholes hadn’t counted on Thailand’s currency going belly up. They hadn’t counted on Russia just saying, ‘No, we’re aren’t going to pay our debts today.’ They simply couldn’t account for everything. And so, by 1998, somehow, $3 billion capital was now supporting – get this - $1.25 trillion worth of risk.

Just to put that in perspective, if the federal government were to have paid that debt, they would be done for the year. Nothing else.

Thankfully, they got bailed out and bought out with nothing more than questions of why the Federal Reserve was stepping in on a private business. That could have created a depression that made the 30s look a banner decade.

But the point is this they were so cocky – so confident in their own understanding of how the world worked that they never thought history could surprise them. A little bit of humility would have gone a long way.