Our allocation to risky assets should vary based on the expected return, volatility, risk aversion, and how much we can earn risk-free. That means we should be taking less risk right now. Listen to learn why.
Topics covered include:
- Why there are so few billionaires
- Why the hedge fund Long Term Capital Management imploded
- Why how much to invest is more important than where to invest
- How the Merton share formula can assist with determining what percent of our wealth to invest in risky assets
- Why are expected outcomes so much greater than the median outcome and why it matters to our investing
Welcome to Money for the Rest of Us. This is a personal finance show on money, how it works, how to invest it, and how to live without worrying about it. I’m your host, David Stein. Today is episode 451. It’s titled, “How Much Should You Invest in Stocks? The Art of Position Sizing in a Volatile Market.”
Long-Term Capital Management
Back in the mid 1990s one of the most successful hedge funds was Long Term Capital Management. The fund was founded in 1994 by two Nobel Prize laureates, Myron Scholes, and Robert Merton, along with a number of very smart traders from Salomon Brothers, including John Meriwether and Haghani.
The initial amount of capital raised was very large for a new hedge fund—a billion dollars. The returns in the first three years were incredible. The net of fee returned from inception through 1997 was 31.2% annualized. The fund never lost money two months in a row, and grew to $7.5 billion, one of the largest hedge funds in the world, even though it was closed to new investors since mid-1995.
This strategy is known as relative value arbitrage, and the idea is that, while related securities, their prices might diverge for a short time due to supply and demand imbalances, that ultimately the prices converge to their true relative value. Each individual bet on its own, if unlevered, wasn’t very risky. But the fund used a great deal of leverage in order to magnify the returns of these small bets.
The strategy obviously worked very well, until it didn’t. In August 1998, Russia defaulted on its government debt, sparking a great deal of financial turmoil and volatility. For example, the MSCI Emerging Markets Index fell 29%, just in the month of August 1998. And the markets moved the different asset types that Long Term Capital Management was using in its strategy; the moves were extreme, much greater than their models assumed. And as a result, Long Term Capital Management lost 90%.
The New York Federal Reserve organized a consortium of large counterparties—investment banks, commercial banks that traded with Long Term Capital Management, that were exposed to huge losses because they had provided leverage to Long Term Capital Management. And the New York Fed organized basically a bailout, where those counterparties invested $3.6 billion in the fund, and got 90% ownership, and bought time for the fund to be liquidated.
In the end, those investment banks had invested earned 10% on their capital, but not the general partners, nor the limited partners in Long Term Capital Management.
Victor Haghani said he personally lost over $100 million in that fund. He wrote, “I was 35 years old at the time, the youngest of the Long Term Capital Management partners. I saw that all my partners, many of whom are like family to me, also thought the fund was a very attractive investment. On top of all this, the fund was far from a black box to me. In fact, it was the investment that I understood the best, of all things I could possibly invest in.”
Haghani was trying to figure out what percent of his wealth should he invest in this investment that he understood, and was poised to do extremely well?
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