Let me tell you about one thing you never ever will want to do. You don’t want to have to get rich twice. Don’t do it. Once you’ve achieved a comfortable level of wealth, don’t do anything that could threaten that position.
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In 2007, Nassim Nicholas Taleb published The Black Swan: The Impact of the Highly Improbable, a book focused on the extreme impact of rare and unpredictable events. It is an essay on one single idea – we tend to be blind when it comes to random unforeseen events that come out of left field and have the potential to flatten us.
Now Talib’s focus was not on predicting such events, but arranging your affairs in such a way as to survive the improbable. After all, we don’t know what we don’t know. So, don’t ever put yourself in a position where you inadvertently risk it all.
Let me tell you about a group of extremely intelligent, highly competent leaders in the field of finance who let their egos and hubris destroy them because they didn’t consider the concept of The Black Swan.
Long-Term Capital Management was one of the world’s most successful hedge funds for a handful of years in the mid-1990s. Founded in 1994 by a who’s who within the world of finance, the company’s board of directors included some of the most intelligent minds in the industry.
Initially, the hedge fund was incredibly successful. It returned 20% in its first year, 43% in the second year and 41% in the third year[1]. It was simply minting money.
The hedge fund’s strategy was simple: by borrowing vast amounts of money, it could take advantage of tiny pricing discrepancies in the global debt markets. But the very system that offered those tremendous returns also unknowingly exposed the firm to extraordinary risks.
At its peak in early 1998, just before the whole tower of bricks came tumbling down, LTCM had equity of $4.8 billion and controlled derivative position(s) with a notional value of approximately $1.2 trillion.[2]
Let me say that again – $4.8 billion invested controlling $1.2 trillion worth of investments! Talk about picking up pennies in front of a bulldozer.
That bulldozer eventually arrived in mid-1998. In just four months, the confluence of the Asian financial crisis and the Russian financial crisis in the global debt markets wiped out all of LTCM’s equity’s capital as margin calls on trades gone bad relentlessly came in. It had no choice but to seek a bailout by a group of large investment banks organized by the Federal Reserve.
In four short months, the principals behind LTCM lost everything. Oh, by the way, they almost took down the entire global financial system.
Didn’t see that one coming…
I will paraphrase Warren Buffett, as he had a lot to say on the demise of Long-Term Capital Management.
“The whole story is really fascinating because the principals, including two Nobel Prize winners, probably had as high an average IQ as any group of people working together in any one business in the country. Just an incredible amount of intellect.
Now combine that with the fact that they had extensive experience in the field of finance that they were operating in. In aggregate, they probably had 350 or 400 years of experience.
And then throw in the third factor that although they were already rich, most of them had virtually all of their very substantial net worths invested the business.
So, they had their own money on the table. Hundreds and hundreds of millions of dollars. Super high intellect, working in a field they knew probably better than anyone.
To me, that is fascinating. To make money they didn’t have and didn’t need, they risked what they did have and did need, and lost it all.”
They went broke.
As the economist Henry Kaufmann once noted, “There are two types of people who often go broke. Those who know nothing, and those who know everything”.
The smart, experienced investors at LTCM simply did not consider the improbable – that a total freeze up in the global debt markets could occur.
But that’s the point.
Such outlier events which can destroy you, are not predictable, and are exactly what Nassim Taleb warned about.
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And it turns out that such unpredictable events are more common than you might imagine.
Prior to 2008, no one imagined that the U.S. housing market would go from boom to bust, causing large amounts of mortgage-backed securities and derivatives to plummet in value, taking down Bear Sterns, Merrill Lynch, Lehman Brothers, Citigroup, AIG and countless other stalwarts of finance along the way, and ushering in the Global Financial Crisis of 2008.
The Twin Towers terrorist attack on September 11th, 2001 was a black swan event that changed the world forevermore.
As was Covid.
You see, the real risk to all of us is not knowing what we don’t know, and certainly not knowing the unknowable. And for that reason, those who have created a level of wealth that is meaningful need to organize affairs in such a way that offers the greatest chance of surviving the unexpected. Call us if you have any questions.
[1] (Lowenstein, 2000, pp. 61, 77,94)
[2] (Ron Rimkus, 2016)