Investment success accrues not so much to the brilliant as to the disciplined.

—William Bernstein

Isaac Newton advanced science and thinking like few others ever have. With an IQ of 190, and the ability to calculate to the 55th decimal by hand, his intellect towered above Charles Darwin and Stephen Hawking. But powerful as his brain was, it was unable to save him from falling prey to our most basic human instincts, namely, greed and envy.

In 1720, as shares of the South Sea Company began to rise and hysteria swept the streets of London, Newton found himself in a precarious situation. He bought and sold the stock, earning a 100% return on his investment. Except shares of the South Sea Company rose eightfold in under six months, and they did not stop going higher just because he decided to collect his profits. Unable to cope with the feelings of regret, Newton jumped back into the stock with three times the amount of his original purchase. He reentered as shares approached their apex and instead of doubling his money, he would lose nearly all of it. When the bubble burst, it took just four weeks for prices to plummet 75%.

This left Newton despondent, and it is said that he could not stand to hear the words “South Sea” for the rest of his life. He got an expensive lesson in just how far intelligence goes when attempting to turn money into even more money. When asked about the direction of the markets, Newton replied, “I can calculate the motions of the heavenly bodies, but not the madness of the people.” Isaac Newton actually was one of the smartest people to ever walk the earth, and not even he was able to resist the sight of other people getting rich without him.

One of the problems many investors face is that we all feel we have a little Isaac Newton in us. We all feel we're above average. In a classic 1977 study, “Not Can, But Will College Teaching Be Improved,” 94% of professors rated themselves above their peer group average.¹ If traders and investors were asked the same question, I would guess that the results would be very similar. You don't have to be Albert Einstein to realize this math doesn't add up. As Charlie Munger once said, “The iron rule of life is that only 20% of people can be in the top fifth.”

To be in Mensa, the largest and oldest high IQ society in the world, members must score in the top 2% of any standardized intelligence test. This means that there are between four and five million brilliant adults living in the United States alone that would qualify for this prestigious society. When you go to your computer screen to buy or sell a stock, there are a lot of these super humans waiting to take the other side of your trade. Therefore, a high IQ guarantees you nothing! This is one of the hardest things for newer investors to come to grips with, that markets don't compensate you just for being smart. Raw brainpower is only one prerequisite to even give yourself a chance of having a positive investment experience. Being smart alone does not determine investment results because markets are not linear. Most formulas eventually fail, if they ever even work at all.

The chances of pulling a nine of spades out of a deck of cards is 1 in 52, but there is no way to calculate the odds of a recession given x, y, and z. With risk assets, one plus two doesn't always equal three, and the graveyard of investors is rife with people who thought they could model their way to above average investing results.

Intelligence in investing is not absolute; it's relative. In other words, it doesn't just matter how smart you are, it matters how smart your competition is. Charlie Ellis brilliantly brought this idea to the forefront in a 1975 article, “The Loser's Game.” He wrote “Gifted, determined, ambitious professionals have come into investment management in such large numbers during the past 30 years that it may no longer be feasible for any of them to profit from the errors of all the others sufficiently often and by sufficient magnitude to beat market averages.”² Not only have ambitious professionals come into investment management, they've also brought with them a whole lot of computer power. These machines have permanently changed the investing landscape. A lot of what used to be considered brilliant is now considered to be standard.

In the 1950s, individuals dominated trading. Now institutions – with nearly unlimited resources – make up 90% of daily trading volume. There are 325,000 Bloomberg terminals and 120,000 Chartered Financial Analysts. Technology and the explosion of information have leveled the playing field.

With any activity that involves both skill and luck, as investing clearly does, as skill and intelligence improve, luck or chance plays an increasing role in the outcome. Michael Mauboussin has written about this idea many times, and he calls it the paradox of skill. The takeaway is that there is a lot of skilled market participants; so, intelligence alone is not enough. Other skills are required. Genius and its limitations are exemplified in no better way than by studying John Meriwether and his band of Einsteins at Long‐Term Capital Management.

John Meriwether founded Long‐Term Capital Management in 1994 and before that he enjoyed a legendary two‐decade career as head of the fixed‐income arbitrage group and vice chairman at Salomon Brothers. At Salomon, he surrounded himself with some of the brightest minds in the industry.

Michael Lewis, who began his career at Salomon Brothers, wrote in the New York Times, “Meriwether was like a gifted editor or a brilliant director: he had a nose for unusual people and the ability to persuade them to run with their talents…Meriwether had taken it upon himself to set up a sort of underground railroad that ran from the finest graduate finance and math programs directly onto the Salomon trading floor. Robert Merton, the economist who himself would later become a consultant to Salomon Brothers and, later still, a partner at Long‐Term Capital, complained that Meriwether was stealing an entire generation of academic talent.”³

This generation of academic talent included Eric Rosenfeld, an MIT‐trained, Harvard Business School assistant professor, and Victor J. Haghani, who received a master's degree in finance from the London School of Economics. Also on his team were Gregory Hawkins, who got a PhD in financial economics from MIT, and Lawrence Hilibrand, who earned two degrees from MIT. In addition to these rock stars, Long‐Term also employed David Mullins, former vice chairman of the US Federal Reserve Board. Meriwether's goal was to outsmart everyone, and this advantage persisted for a long time.

His band of wizards would became the most powerful, profitable group inside of Salomon Brothers. In a year in which John Gutfreund, CEO, earned $3.5 million, Meriwether was reportedly paid $89 million.⁴ But after a scandal at the Treasury rocked the bank, Meriwether was forced to resign. Shortly thereafter, his loyal protégés would follow.

Meriwether launched Long‐Term Capital Management with two giants of financial academia at his side, who would both later become Nobel Laureates. One was Robert Merton, who earned a bachelor of science in engineering mathematics from Columbia University, a master of science from the California Institute of Technology, and his doctorate in economics from MIT. Prior to joining Salomon Brothers, Merton taught at the MIT Sloan School of Management until 1988, before moving to Harvard University. His pedigree was flawless, and the influence Merton had on the world of finance cannot be overstated. Stan Jonas, a derivatives wizard once said, “Most everything else in finance has been a footnote on what Merton did in the 1970s.”⁵

Meriwether was also able to recruit Myron Scholes, cocreator of the Black‐Scholes option pricing model. Scholes received his MBA and PhD at the University of Chicago Booth School of Business. He then went on to work at the MIT Sloan School of Management before coming back to teach at Chicago. It should be clear by now that the résumés at Long‐Term Capital Management were truly second to none. Nothing in finance had ever even come close. In a Fortune article, Carol Loomis said, “There may be more IQ points per square foot than in any other institution extant.”⁶ They were head and shoulders above everyone else and they knew it. Scholes once described themselves as “Not just a fund. We're a financial‐technology company.”⁷

The minimum investment at LTCM was $10 million and their management fees were 2 and 25, above the standard industry practice of 2 and 20. The high minimum and above average fees did not deter investors. The smartest minds attracted the smartest and biggest clients, “including David Komansky, head of Merrill Lynch; Donald Marron, chief executive of Paine Webber; and James Cayne, chief executive of Bear Stearns.”⁸ They also took money from giant institutions like the Bank of Taiwan, the Kuwaiti pension fund, and the Hong Kong Land & Development Authority. Even Italy's central bank, which notoriously did not invest in hedge funds, forked over $100 million.⁹

Long‐Term Capital Management opened their doors in February 1994 with $1.25 billion, the largest hedge fund opening ever up until that point in time. Their performance was strong right out of the gate. In the first 10 months that they were open, they earned 20%.¹⁰ In 1995, the fund returned 43%, and in 1996, they earned 41% in a year in which their profits totaled $2.1 billion:

To put this number into perspective, this small band of traders, analysts, and researchers, unknown to the general public and employed in the most arcane and esoteric of businesses, earned more that year than McDonald's did selling hamburgers all over the world, more than Merrill Lynch, Disney, Xerox, American Express, Sears, Nike, Lucent, or Gillette—among the best‐run companies and best known brands in American business.¹¹

Long‐Term Capital Management was on a roll indeed. Their returns were high and steady, with their worst losing month being just a 2.9% decline.¹² It seemed too good to be true. In the fall of 1997, Robert Merton and Myron Scholes both were awarded with the Nobel Prize in Economics. Of their achievement, The Economist wrote that they had turned “risk management from a guessing game into a science.” Their returns continued uninterrupted and they managed to quadruple their capital without having a single losing quarter.¹³

But the good times would not last forever, because on Wall Street, such winning strategies tend to have a short half‐life. Big results breeds big envy, and eventually, every trading secret gets out. LTCM's arbitrage strategies were no exception. As Eric Rosenfeld, an LTCM trader, said, “Everyone else started catching up to us. We'd go to put on a trade, but when we started to nibble the opportunity would vanish.”¹⁴ Because opportunities were becoming harder to come by, at the end of 1997, after a 25% gain (17% net of fees), they made the decision to return $2.7 billion of capital to their original investors.¹⁵ They returned all the money that had been invested after 1994 as well as all of the investment profits made before that date.¹⁶

This became problematic because the opportunities they sought were not large to begin with so their strategy required a ton of leverage. But when they returned $2.7 billion, they did not take down their position sizes, so their leverage went from 18:1 to 28:1.¹⁷ According to Loomis, LTCM wasn't planning to make a hefty return, and they believed the risk was low, but their leverage in both the United States and Europe soared. LTCM had about $40 million at stake for every point in volatility the markets moved.¹⁸

At one point, they had $1.25 trillion in open positions and they were levered 100:1. This leverage would lead to one of the largest disappearing acts of wealth the world has ever seen.

In May 1998, as the spreads between US and international bonds widened more than their models anticipated, Long‐Term lost 6.7%, their worst monthly decline up until that point. In June, the fund fell another 10%, and they were staring down the barrel of a 14% decline for the first half of the year. Russia was at the epicenter of Long‐Term's downward spiral, and in August 1998, as oil – their main export – fell by one‐third and Russian stocks were down by 75% for the year, short‐term interest rates skyrocketed to 200%. And then the wheels fell off for Meriwether and his colleagues. All the brains in the world couldn't save them from what was coming.

LTCM took financial science to its extreme – to the outer limits of sanity. They coldly calculated the odds of every wiggle for every position in their portfolio. In August 1998, they calculated that their daily VAR, or value at risk (how much they could lose), was $35 million. August 21, 1998, is the day when their faith should have evaporated, along with the $550 million that they lost.¹⁹ It was the beginning of the end.

By the end of the month, they had lost $1.9 billion, putting the fund down 52% year‐to‐date. The death spiral was in full effect. “On Thursday September 10, the firm had lost $530 million; on Friday, $120 million. The next week it hadn't stopped: on Monday, Long‐Term dropped $55 million; on Tuesday, $87 million. Wednesday, September 16, was especially bad: $122 million. Like a biblical plague, the losses gave no respite.”²⁰ On Monday, September 21, they lost $553 million.²¹

In the end, in an effort to prevent their failed positions from poisoning the entire financial system, the Federal Reserve Bank of New York would orchestrate a 90%, $3.6 billion takeover, led by 14 Wall Street banks. The fall of Long‐Term Capital Management was on a scale the industry had never before witnessed. It was two and a half times as big as Fidelity's Magellan Fund, and four times as big as the next largest hedge fund.²² Their fund had $3.6 billion in capital, of which two‐fifths was personally theirs. In five weeks, it was gone.

How could smart people possibly be so stupid? Their biggest mistake was trusting that their models could capture how humans would behave when money and serotonin are simultaneously exploding. Peter Rosenthal, Long‐Term's press spokesman once said, “Risk is a function of volatility. These things are quantifiable.”²³ There is a lot of truth in this; after all, at their peak in April 1998, $1 invested turned into $2.85, a 185% profit in just 50 months! But Nassim Taleb, in Fooled by Randomness, was also right when he said, “They made absolutely no allowance in the episode of LTCM for the possibility of their not understanding markets and their methods being wrong.”²⁴

Jim Cramer said, “In short, this was a seminal blowup. It struck at the heart of all of those on Wall Street who think that this racket is a science that can be measured, structured, derived and gamed.”²⁵

They were able to calculate the odds of everything, but they understood the possibility of nothing. The lesson us mere mortals can learn from this seminal blowup is obvious: Intelligence combined with overconfidence is a dangerous recipe when it comes to the markets.